Energy: A False Sense of Security for Oil Markets

• 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 (mmb/d), combined, this group has engineered a temporary supply shortage in an effort to realign global inventories with the long-term average before the cuts expire at the end of 2018.
• However, several months of stagnating shale growth, driven by a sharp increase in drilled-but-uncompleted wells and the fallout from Hurricane Harvey, have lulled oil markets into a false sense of security. The inevitable resumption of growth in the U.S., coupled with expansion in Libya and Nigeria, will likely nudge crude stockpiles higher again in 2018--whether other OPEC members comply with fully agreed production targets or not.
• Even before the OPEC cuts are lifted, supply is likely to outstrip near-term demand growth and tip the industry into oversupply in 2018, driven by rapidly growing U.S. output. Our 2018 and midcycle forecasts for West Texas Intermediate are still $48/bbl and $55/bbl, respectively.
• Despite our bearish outlook for near- and long-term oil prices, we see pockets of opportunity in the oil and gas space. Energy sector valuations look fairly valued at current levels, with an average price/fair value estimate of 0.98. Still, on a relative basis, energy is one of the cheaper sectors, with several others trading at a price/fair value above 1.05.

As many expected, OPEC announced on Nov. 30 that it will extend its crude-oil production cuts through the end of 2018. The impact of these cuts will fall short of what the cartel and its partners are hoping for, however.

Several months of stagnating shale growth, driven by a sharp increase in drilled-but-uncompleted wells and the fallout from Hurricane Harvey, have lulled oil markets into a false sense of security. The inevitable resumption of growth in the United States, coupled with expansion in Libya and Nigeria, will probably nudge crude stockpiles higher again in 2018, whether other OPEC members comply with fully agreed production targets or not.

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 market share to U.S. producers, oil markets have major problems looming on the horizon. Neither is likely to occur.

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. The U.S. shale industry still has a long runway of Tier 1 drilling opportunities, especially in key growth basins (the Permian, for example). And there's ample scope for further advances in productivity and efficiency, offsetting any cost reinflation from shale service providers and capping break-evens for marginal producers.

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 online. 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

Enterprise Products Partners

EPD

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $30.00

Fair Value Uncertainty: Low

5-Star Price: $24.00

We consider Enterprise Product Partners' units to be about 20% undervalued for this best-in-class midstream partnership with a wide moat rating and Exemplary stewardship. At our fair value estimate, units are valued at about 14 times 2018 EBITDA and a 5.7% distribution yield.

We do not believe the stock is pricing in improving natural gas liquids fundamentals, and investors are focused rather myopically on the recent announcement to scale back growth in distribution payouts to unitholders to a $0.0025 quarterly increase from a $0.005 increase (which doesn't affect our fair value).

With wider frac spreads, improved utilization for both pipelines and fractionation plants amid higher oil, gas, and NGL volumes, and export opportunities well in hand combined with the potential to self-fund and even buy back undervalued units in the future, we see Enterprise as a compelling opportunity. Broadly, these factors support our 8% five-year CAGR for EBITDA.

We believe the partnership’s diverse operations providing exposure to oil, NGLs, and natural gas, management's proven ability to pivot skillfully to take advantage of market opportunities (petrochemical investments, for example), and the overall quality of the firm emphasize the strength of the opportunity available to investors today.

Spectra Energy Partners

SEP

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $50.00

Fair Value Uncertainty: Low

5-Star Price: $40.00

We think Spectra Energy Partners offers an attractive mix of valuation, business quality, and yield for investors. It has been dragged down with the rest of the master limited partnerships, yet Spectra's risk profile, growth potential, and assets are much different than its peers.

Spectra has billions of dollars' worth of projects currently in execution and billions more of identified growth projects, providing solid distribution growth visibility through the end of the decade. Utilization on its pipes is high, and all pipelines generate fixed-fee cash flow from long-term contracts, making Spectra one of the most stable cash generators we cover and a refuge in volatile times. As the incumbent in many markets with high barriers to entry, Spectra has the ability to continue investing in incremental assets at high rates of return to strengthen its position, supporting its wide moat rating.

Energy Transfer Partners

ETP

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $23.00

Fair Value Uncertainty: Medium

5-Star Price: $16.10

Uncertainty about long-term plans for the Energy Transfer family of companies seems to be holding market valuations down relative to what we think is fair value. Investors seem to be waiting for answers to questions regarding a potential consolidation, long-term growth opportunities, and management's strategic direction. Yet, the Energy Transfer assets remain well positioned and highly profitable.

In the past decade, Energy Transfer has built itself into one of the largest midstream energy companies with an enviable network of natural gas infrastructure primarily in Texas and the U.S. midcontinent region. Recent moves to simplify the corporate structure continue to diversify the Energy Transfer family's exposure across the U.S. energy value chain and improve its balance sheet after several years of outsize growth investment. We see double-digit distribution growth in the new consolidated structure as projects go into service in 2017-19.

Quarter-End Insights

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