Energy: Despite Geopolitical Wildcards, the Reckoning Is Still Coming for U.S. Shale Producers
The longer the delay, the worse the supply onslaught becomes.
- Crude fundamentals look healthier than they've been for years, largely because of voluntary curtailments from OPEC and its partners. By giving up 1.8 million barrels per day, or mmbpd, combined, this group has engineered a temporary supply shortage in an effort to realign global inventories with long-term averages.
- Helping OPEC's efforts are geopolitical supply disruptions. Venezuela remains in crisis, and its oil production has slumped further after an initial plunge in the fourth quarter of 2017. President Trump's decision to abandon the Iran nuclear accord is likely to widen this year's crude oil supply-demand imbalance, accelerating the decline of global inventories and potentially leaving the market with fewer days of supply on hand by year-end than it has had at any point in the past eight years.
- However, we believe the market continues to underestimate the capacity of the shale industry to throw oil markets back into oversupply. Crude prices have largely held above $65 per barrel for West Texas Intermediate in 2018, which provides attractive economics for many U.S. producers. But the reckoning may not happen as quickly as we previously thought amid supply disruptions. Eventually, we expect pain for oil prices as growing U.S. production serves as the primary weight to tip oil markets back into oversupply.
- Our midcycle forecast for WTI is still $55/bbl. We think oil bulls are failing to recognize the vast potential for further productivity gains from U.S. producers and are unduly worried about prime shale acreage running out more quickly than it really will.
- Despite our bearish outlook for 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 to fair value estimate of 1.00.
We previously viewed the late 2017 decline in global crude stockpiles as a temporary respite, to be derailed by the shale surge that still looks likely this year. However, economic malaise in Venezuela has triggered precipitous output declines, and it isn't clear how quickly this can be rectified, if at all. The likelihood of hefty outages in Iran has soared now that Trump abandoned the Iran nuclear accord. And other OPEC producers are fanning the flames with even steeper cuts than they originally agreed to. All this creates a supply vacuum this year that can easily offset U.S. growth, however strong, and prolong the illusion that shale isn't a threat. Regardless, oil prices must pare back eventually to prevent catastrophic growth from U.S. shale.
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.
Geopolitical disruptions have always been a feature of global oil markets, and such disruptions can have a lasting impact. The shortages faced this year by Venezuela (and potentially Iran) may take months or even years to overcome. But neither affects our long-term outlook. We already believe that the growth trajectory of U.S. shale will cause problems for oil markets eventually. Adding rigs and accelerating drilling operations further will only fan the flames. Yet that is the likely response if West Texas Intermediate crude remains in the $65/bbl area.
The U.S. light tight oil rig count has spiked above 650, which is well above the medium level that keeps the market balanced in the long run, setting up a shale surge that could overwhelm the market after 2018. But the industry hasn't recognized the danger. Because of the long lag between adding rigs and seeing a production response, the impact of the most recent additions hasn't been felt yet. And to make matters worse, temporary equipment bottlenecks and labor shortages are still slowing completions and masking shale's growth potential (only 70% of Permian Basin wells drilled in 2017 were completed). When these are resolved, the shale industry will find itself rapidly overheating unless producers start slowing down, and only a drop in oil prices can persuade them to do that. 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 the near term, 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 breakevens 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.
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $50
Fair Value Uncertainty: Medium
5-Star Price: $35
Wide-moat Enbridge represents our Best Idea for investors in the Canadian midstream sector. We see nearly 50% upside in the stock, while on average the Canadian midstream sector looks modestly undervalued. 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). Investors appear to be skeptical that the project will obtain its final approval amid continued protests and opposition. As detailed in our January Select presentation "Best Idea Enbridge Is a Triple Threat," we believe the project will obtain the remaining approval from the state of Minnesota. A final decision is expected by July, which we think will serve as a catalyst for the stock. 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 6.3%. As detailed in our May Select presentation "Investors' Concerns Over Enbridge's Dividend Are Overblown," we believe that Enbridge can meet its targeted dividend growth, regardless of the ruling on Line 3.
Petroleo Brasileiro SA Petrobras
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $16
Fair Value Uncertainty: High
5-Star Price: $9.60
While Petrobras trades at one of the greatest discounts to our fair value estimate in the energy sector, we'd advise investors to proceed with caution. Recent revisions to the domestic product pricing formula and the subsequent resignation of the CEO, who was instrumental in righting the ship the last few years, have heightened the risk of government intervention in Petrobras' affairs. That said, we think the market is overly discounting the impact of those revisions and barring further intrusion into pricing or capital allocation decisions, shares are undervalued. As such, Petrobras should deliver long-term rewards as it continues to grow highly profitable pre-salt volumes and reduces debt in the coming years.
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $17
Fair Value Uncertainty: Very High
5-Star Price: $8.50
Cenovus is our best pick among our Canadian integrated stocks and one of our Best Ideas. The stock is currently trading at a 40% discount to its fair value estimate, while on average the industry looks fairly valued. As detailed in our October Select presentation, "The King in the North: Cenovus Energy," 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 SAP technology. Furthermore, 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 that the stock presents an attractive opportunity for long-term investors.
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Energy: Despite Geopolitical Wildcards, the Reckoning Is Still Coming for U.S. Shale Producers The longer the delay, the worse the supply onslaught becomes.
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