Energy: All Roads Point to Oversupply in 2018

• Crude fundamentals look healthier than they've been for years, largely due to voluntary curtailments from OPEC and its partners. By giving up 1.8 million barrels per day combined, this group has engineered a supply shortage to realign global inventories with the long-term average before the cuts expire in March 2018.
• The cartel might pay a steep price for any near-term benefit, however. We believe it is underestimating the ability of shale producers in the U.S. to rapidly increase volumes in a $50-$55/barrel environment (West Texas Intermediate). After several upward revisions, the International Energy Agency currently expects U.S. crude production to end the year 0.8 mmb/d higher than year-end 2016, and that looks conservative, as we forecast 1 mmb/d. The rapid U.S. shale growth in the back half of the year will meaningfully increase U.S. oil supply.
• Once the OPEC cuts are lifted, full OPEC production coupled with rapidly growing U.S. output is likely to outstrip near-term demand growth and could easily tip the industry back into oversupply in 2018. Our 2018 and midcycle forecasts for WTI are still $45/bbl and $55/bbl, respectively.
• The energy sector looks fairly valued at current levels with an average price/fair value of 0.95. Still, on a relative basis, energy is one of the cheaper sectors, with several others trading at a price/fair value above 1.00.

OPEC's production cuts and strong demand growth have 2017 crude fundamentals in their best shape since oil prices crashed two years ago. The consensus outlook is that market fundamentals are now strong enough to remain healthy even after OPEC returns to higher production.

This might have been the case a few months ago, but the odds of this scenario playing out have since markedly worsened. The major increases in shale activity now have U.S. oil production firmly on a path toward rapid growth, even if shale rig counts don't increase from current levels. This growth--plus the eventual production increases from OPEC--is likely enough to erase any market tightness and throw crude markets back into oversupply within the next three to 15 months.

What's obvious by now is that current oil prices provide economics that are very attractive to the major U.S. shale producers. This has created the conditions that will allow tight oil to grow rapidly and is a reality that even forthcoming cost inflation will not change. Unless shale producers become more disciplined or OPEC resigns itself to permanently ceding share to U.S. producers--neither of which is likely to occur--oil markets have major problems looming on the horizon.

The U.S. horizontal rig count remains well below the 2014 peak, but due to remarkable advances in efficiency and well productivity, it is already high enough to drive very strong growth for several years. Therefore, next year's output is likely to exceed the "call on U.S. shale." But the industry can't react quickly when it recognizes the danger because many of its rigs operate under fixed-length contracts with steep termination penalties. And when the rig count does decline, there will be an additional overhang related to the lag between drilling a well and bringing it on line. Nothing is ever certain in the world of oil, but a crude awakening for energy investors could very well be near at hand.

Looking past 2018, we expect a midcycle price of $55/bbl WTI. This estimate is based on our cost outlook for U.S. shale production, which we expect to be the marginal source of global supply. Sustainably lower shale break-evens mean the era of low-cost oil is here to stay. Our view on lower shale costs is driven in large part by our expectations for minimal inflation in proppant and pressure pumping costs.

Top Picks

Cenovus Energy

CVE

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $17.00 (CAD 21.00)

Fair Value Uncertainty: Very High

5-Star Price: $8.50 (CAD 10.50)

Cenovus is our best pick among our Canadian integrated stocks. The stock is currently trading at a deep discount to its fair value estimate while on average the industry looks fairly valued. We believe that the market is narrowly focused on the company's temporarily high leverage levels and overlooking the immense growth potential in the company's oil sands reserves that can be brought on line with industry-leading, low-cost solvent-aided process technology. Furthermore, we think the market is underestimating the application of SAP technology to the company's recent FCCL acquisition, which will provide Cenovus with ample opportunities to bring on low-cost bitumen production. Growth projects that once faced challenged economics are now positioned to add significant value to shareholders over the long term. Consequently, we believe the stock presents an attractive opportunity for long-term investors.

RSP Permian

RSPP

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $48.00

Fair Value Uncertainty: High

5-Star Price: $28.80

RSP Permian is currently trading at a discount of more than 30% to our fair value estimate. It operates exclusively in the Permian Basin, which offers very attractive drilling economics and is expected to be a major growth center for U.S. shale over the next several years. The company's acreage contains almost 6,000 horizontal drilling locations, supporting several decades of activity at the current run rate, and almost all of it is in core areas within the Midland and Delaware basins--there's no "filler" acreage in less lucrative peripheries.

Although the entire industry is focusing on cutting costs and enhancing efficiency, RSP is well ahead of the curve. In 2016, it reported finding and development costs of $6 per barrel of oil equivalent and operating expenses of $11 per boe. Of the company's production that year, 73% was crude oil, which it was able to sell at a discount of just 5% to the WTI benchmark (because of its proximity to local infrastructure). That translates to a WTI break-even of less than $25/bbl, which is well below the peer average and positions the company to cope with a difficult commodity price environment.

Management forecasts 90% production growth in 2017, coming off a low base, and the company is still on track to hit that goal. Preliminary guidance for 2018-19 suggests annual growth of about 30% in both years, with two additional rigs added each year. Adding rigs seems unlikely in the crude environment we forecast, but factoring in reasonable productivity improvements, we think the company can come close to this target with the rigs it is already running (we forecast 25% growth in 2018).

Royal Dutch Shell

RDS.A

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $65.00

Fair Value Uncertainty: Low

5-Star Price: $52.00

Uncertainty around the safety of the dividend, the integration of BG Group, and the ability to achieve its 2020 free cash flow and return targets has weighed on Shell's share price. We think these concerns are overblown, however, and at current levels the shares present a compelling opportunity. We see ample room for cost-cutting, upstream margin improvement, and reduced capital intensity that should ultimately improve free cash flow generation and secure the dividend. Meanwhile, the past few quarterly results have demonstrated that Shell is well on its way to achieving 2020 targets.

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