For the second quarter in a row, the Morningstar US Energy Index has eclipsed the overall market, beating the aggregate index by over 28% as of March 26.
Energy stocks have caught up after a tough 2020 - source: Morningstar
Although prospects for global herd immunity have receded, given the spread of coronavirus variants and uneven vaccinations, we continue to expect global crude consumption to return to 2019 levels within two years. Developed markets can still achieve herd immunity if they reach critical mass vaccination before variants become widespread. And elsewhere, life can still mostly return to normal as long as vaccines continue to lower the risk of severe disease (even if they can't completely stop the spread).
Even with the rally, we still see energy as undervalued, with the average stock trading at a 9% discount. Opportunities exist across all segments, particularly midstream, services, and integrated, which trade at a 10%, 30%, and 14% discount to intrinsic value, respectively. Exploration and production stocks have surged in the last three months, and on average the group is now 6% undervalued (though a handful of 4-star stocks are still underappreciated, in our view).
Midstream and services stocks still mostly undervalued - source: Morningstar
The ongoing rollout of COVID-19 vaccinations around the world will be the main catalyst for year-on-year demand growth of 6.3 million barrels per day in 2021. On the supply end, producers remain cautious. Though oil prices have fully recovered since the start of the pandemic, OPEC remains skeptical about the pace of the recovery and has extended cuts into April. Likewise, U.S. shale firms are reluctant to increase activity, and volumes could contract slightly in 2021. The hesitance of U.S. producers to pursue growth could allow OPEC+ to further delay unwinding the cuts, without risking a loss of market share.
Global demand should reach 2019 levels by 2022 - source: Morningstar
As a result, the market looks very tight in 2021: We now anticipate a supply deficit of 1.9 mmb/d this year (compared with our prior forecast of 1.7 mmb/d). This should normalize global crude inventories relatively quickly. However, the magnitude of the implied draw is apparently alarming traders, judging by what we consider frothy oil prices. The West Texas Intermediate benchmark is currently 12% higher than our $55/bbl midcycle forecast, which reflects the marginal cost of supply. To get prices back to midcycle levels this year, we would need to see a meaningful setback in COVID vaccinations or an abrupt change in strategy from OPEC or the U.S. shale industry.
The U.S. shale recovery has been lethargic so far - source: Morningstar
Cheniere Energy LNG Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $89 Fair Value Uncertainty: High
Cheniere is well-positioned to be the exporter of the incremental liquefied natural gas supplied to the global market over the next few years, particularly as demand ramps up from China. Our Cheniere model has EBITDA of $5.5. billion in 2024, which is roughly the midpoint of Cheniere's guidance. Given the firm's performance during COVID-19, we are very confident that Cheniere can reach our forecast, and our valuation implies about a 10 times EBITDA multiple on 2024 EBITDA, close to what we are valuing similar high-quality U.S. midstream peers today that have substantially less certainty around their future EBITDA.
EOG Resources EOG Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $94 Fair Value Uncertainty: Medium
EOG doesn't like overpaying for assets. The firm mostly avoids expensive corporate M&A, and instead focuses on overlooked or underexplored acreage. But that hasn't stopped it from assembling a top-tier shale portfolio encompassing the major U.S. oil plays. The firm's competitive edge is strengthened by its scale and technical prowess, and we're confident the firm can stay near the front of the pack on profitability, given its deep inventory of "premium" drilling opportunities. That sets the firm up well for sustainable free cash generation under a wide range of commodity scenarios, supporting further dividend hikes. Unlike some peers, EOG's balance sheet is already rock solid, so it doesn't need to divert any operating cash to repay debt.
Schlumberger SLB Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $47 Fair Value Uncertainty: High
We think the market is overly pessimistic about international oil and gas capital expenditure growth. Schlumberger is our top pick to play this market mistake, given its top international exposure (63% of 2018 revenue) and underrated value-creation prospects via its integrated businesses. Schlumberger is poised to gain market share and boost its profitability as a result of its integrated businesses (such as Schlumberger Production Management), which are saving costs in oil and gas development. The company’s shares are trading far below our fair value estimate.