Energy: A Drop in Oil Prices Has Made Energy Stocks More Attractive

After outperforming the broader market for most of 2018, the Morningstar Global Energy Index dropped 22% in the fourth quarter through Dec. 20. (Exhibit 1), owing to the steep drop in oil prices that began in October.

Exhibit 1: Global energy index vs. global equity index

After touching $75 per barrel in early October, West Texas Intermediate crude plummeted below our unchanged midcycle price of $55 per barrel (Exhibit 2). The more than 30% drop in oil prices from the 2018 peak has coincided with a period of weakness for broader equity markets, making energy stocks look much more attractive than they did when OPEC met in June. The median price/fair value in our global energy coverage is 0.77. Roughly 8% of our energy coverage trades in 5-star territory, among the higher shares at a sector level (Exhibit 3).

Exhibit 2: Our long-term oil price forecast is above current prices

Exhibit 3: Energy star rating distribution for sector and by key industry

OPEC and its partners announced on Dec. 7 a deal to cut crude production by 1.2 million barrels per day beginning in 2019. OPEC will account for 800,000 bpd of the cut, with its partners, led by Russia, responsible for the remaining 400,000. After briefly opening its oil spigots in the second half of this year, OPEC will cut production again, as oil prices have declined greatly from October highs.

We said in June that a shale-induced supply surge would be the likely catalyst to sink oil prices toward our midcycle price. This has largely played out, with U.S. production up 7.5% from June to September and more than 14% since the end of 2017. Other factors have contributed to the oil price decline since the last OPEC meeting, including higher-than-expected Iran production and demand worries as prices rose.

Given our bearish long-term oil outlook (we're still 15% below long-term consensus), we think investors are more likely to find value in the volume-driven areas of the sector, namely midstream and refining. Nonetheless, the recent sell-off has created buying opportunities for multiple integrateds, exploration and production companies, and services firms, too. Over the long run, we think U.S. shale well cost inflation will fall short of consensus, owing greatly to the no-moat nature of many shale services, and that wider adoption of current technologies coupled with decades of attractive drilling opportunities (Exhibit 4) will contain unit break-evens.

Exhibit 4: Decades of attractive shale drilling opportunities remain

Top Picks

Enbridge ENB

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $47

Fair Value Uncertainty: Medium

5-Star Price: $32.90

Wide-moat Enbridge represents our best idea for investors in the Canadian midstream sector. We see 40% upside in the stock, while on average the Canadian midstream sector looks fairly valued. We believe the market doesn't realize the full potential of the company's growth portfolio, which is highlighted by the Line 3 replacement project (Canadian Mainline pipeline expansion), approved in June. Accordingly, we expect Enbridge to generate significant free cash flow, allowing the company to increase its dividend at approximately 10% annually over the next three years. The company is currently yielding approximately 7%.

Enterprise Products Partners EPD

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $35.50

Fair Value Uncertainty: Low

5-Star Price: $28.40

We think investors do not appreciate Enterprise’s leading position as the exporter of incremental hydrocarbon, whether liquefied petroleum gas, oil, or ethane. We expect NGL production and exports to sharply exceed consensus U.S. NGL production estimates, which imply that the U.S. cannot supply enough ethane to meet the $150 billion-plus steam cracker expansion underway, and U.S. NGL exports will actually decline from existing levels.

Schlumberger SLB

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $65

Fair Value Uncertainty: High

5-Star Price: $37.20

Schlumberger stands out as high-quality and favorably valued. The market seems to be underrating prospects for the SPM business, a fully integrated services model that aspires to deliver a sea change in oil and gas development costs. SPM is already delivering returns on capital far ahead of the rest of the company, and therefore the business will lift Schlumberger's profitability up as it grows as a share of revenue in years to come.

Exhibit Sources: Morningstar data and estimates. Data as of Dec. 20, 2018.