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Energy: Looming U.S. Shale Supply Should Temper Optimism

Huge output decline boosts near-term fundamentals, but lofty prices likely to trigger dangerous shale growth later.

Securities In This Article
Enbridge Inc
Energy Transfer LP
  • 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 temporary supply shortage in an effort to realign global inventories with long-term averages.
  • Helping OPEC's efforts, the precipitous decline in Venezuela's output during the fourth quarter of 2017 has proved far steeper than expected and will most likely prop up oil fundamentals for most of the year.
  • However, growth from U.S. shale still looms large. Crude prices have largely held above $60 per barrel for West Texas Intermediate in 2018, which provides an attractive economics for many U.S. producers. 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 near- and long-term oil prices, we see pockets of opportunity in the oil and gas space. Energy sector valuations look modestly undervalued at current levels, with an average price/fair value estimate of 0.94. Still, on a relative basis, energy is one of the cheaper sectors, with several others trading at a price/fair value above 1.03.

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. But the precipitous decline in Venezuela’s output has proved far steeper than expected and will most likely prop up oil fundamentals for the rest of 2018. 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 WTI crude remains in the $65/bbl ballpark.

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. 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 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 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

Spectra Energy Partners


Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $48

Fair Value Uncertainty: Low

5-Star Price: $38.40

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 its risk profile, growth potential, and assets are much different than its peers. Spectra has billions of dollars' worth of projects currently in execution, and parent Enbridge is committed to making Spectra its growth engine for U.S. projects. This gives us confidence that it can grow distributions at the high end of management’s 4%-6% target. Utilization on Spectra's 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. 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.



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 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. We believe the project will obtain the remaining approval from the state of Minnesota. A final decision is expected by April, 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 6.5%.

Energy Transfer Equity


Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: $22

Fair Value Uncertainty: Medium

5-Star Price: $15.40

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

Stock Market Outlook: Stocks Look Slightly Overvalued Today 4- and 5-star stocks are harder to come by in today's market, but a few values are still out there.

Credit Market Insights: A Decidedly Negative Quarter for Fixed-Income Markets Rising rates and widening credit spreads took their tool in the first quarter of 2018.

Basic Materials: Still Overvalued Despite Protective Tariffs Our bearish view on the mining and metals sector means the basic materials coverage universe trades at a market-cap-weighted 30% premium to our fair value estimates.

Communication Services: The Most Undervalued Sector We Cover We see value in several firms as consumers migrate away from traditional TV bundles and Europe invests in fiber and 4G.

Consumer Cyclical: Confidence, Demographics Support Consumption Gains E-commerce market share gains present challenges for some, but trends continue to support healthy profitability for many companies.

Consumer Defensive: Looking to M&A, Online Sales for Growth We see a few values for long-term investors amid intense competition.

Financial Services: Regulations and Interest Rates Remain in the Spotlight for 2018 We see financial services stocks across the globe as fairly valued today.

Healthcare: Values Among Drug, Biotech, and Supply Chain Firms Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first- quarter.

Industrials: Healthy Demand, But Few Values Among a mostly fairly valued industrials sector, some good values remain.

Real Estate: Rising Rates Won't Derail Strong Fundamentals REITs have focused on strengthening their portfolios, deleveraging, and capital recycling in the face of higher bond yields and new construction.

Technology: Shift to Cloud Computing Most Important Story The sector looks modestly overvalued as a whole, but there are some attractive firms in enterprise software and IT services.

Utilities: Under Pressure in Early 2018 Utilities sell-off presents opportunities for long-term investors.

Venture Capital Outlook: Despite Slow Volume, Liquidity Prospects Remain We expect ample opportunity in the VC-backed IPO market as alternative liquidity routes gain popularity.

Private Equity Outlook: Carveouts on the Rise as Fundraising Slows As dealmakers look to innovate their origination process, we anticipate a continued rise in take-privates and corporate divestitures.

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About the Author

Joe Gemino

Senior Equity Analyst
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Joe Gemino, CPA, is a senior equity analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.. He covers Canadian oil and gas companies.

Before joining Morningstar in 2015, Gemino held equity analyst roles for Goldman Sachs and Gate City Capital Management. Before business school, he was a technical accountant for Citigroup and Northern Trust.

Gemino holds a bachelor’s degree and a master’s degree in accountancy from the University of Notre Dame along with a master’s degree in business administration from the University of Chicago Booth School of Business. He holds the Certified Public Accountant designation.

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