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Energy: Oil Prices Remain Unsustainably High, With U.S. Shale Growth Still Looming

The market continues to underestimate the capacity of the shale industry to eventually throw oil markets back into oversupply.

Securities In This Article
Enbridge Inc
Cenovus Energy Inc
Enterprise Products Partners LP
  • Crude fundamentals continue to look healthy despite OPEC's June decision to increase production by 600,000 barrels a day beginning in the third quarter of 2018. OPEC's cuts have largely served their purpose, with oil inventories having shrunk considerably in the past several quarters. We had always projected that OPEC and its partners would eventually turn the spigots back on, given OPEC's lack of history sustaining longer-term production cuts.
  • Helping OPEC's efforts are geopolitical supply disruptions coupled with temporary Permian pipeline shortages. Venezuela remains in crisis, and its oil production has slumped further after an initial plunge in the fourth quarter of 2017. U.S. President Donald 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 eventually throw oil markets back into oversupply. U.S. production reached a new high-water mark in June and should keep hitting new records, though that may come in fits and starts due to temporary Permian pipeline shortages.
  • Crude prices have largely held above $65 per barrel for West Texas Intermediate in 2018, which provides 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 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. The energy sector currently trades at an average price to fair value estimate of 0.99, with more opportunity in industries like midstream that are less dependent on the oil price level and more overvaluation in industries like oilfield services that have a much higher oil price beta.

We previously viewed the late 2017 decline in global crude stockpiles as a temporary respite, to be derailed by the shale surge that grew ever more inevitable due to the positive impact high oil prices have on oil production. 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. 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 and temporary Permian pipeline bottlenecks 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 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. light tight oil rig count has spiked above 650, which is well above the "Goldilocks" 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.

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



Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $49 (CAD 64)

Fair Value Uncertainty: Medium

5-Star Price: $34.30 (CAD 44.80)

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). Line 3 received its final approval in June, which we expected. 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%.

Enterprise Products Partners


Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $35.50

Fair Value Uncertainty: Low

5-Star Price: $28.40

Enterprise Products Partners is one of the cheapest wide-moat partnerships in our midstream coverage. It has an Exemplary stewardship rating, and we view it as one of the industry’s highest-quality names. With the removal of the overhang from the Federal Energy Regulatory Commission's rulemaking effort related to the disallowance of a recovery of income taxes, we think investor perception toward master limited partnerships is improving. To be clear, we don't believe the FERC ruling had any material impact on Enterprise because it primarily uses negotiated rates for its pipelines. However, we think the focus has now shifted back toward Enterprise fundamentals, and particularly NGLs. The volume growth outlook for U.S. hydrocarbons remains very healthy, as does Enterprise’s leading position as the exporter of the incremental hydrocarbon whether it be liquefied petroleum gas, oil, or ethane. Further, we continue to believe Enterprise Products Partners is well positioned for the master limited partnership investor base transition, as the industry shifts toward a total-return-based approach versus focusing solely on dividend/distribution growth. Enterprise eliminated its incentive distribution rights years ago and has consistently maintained a healthy coverage ratio above 1.2 times. The partnership is now seeking to fully self-fund $1.5 billion of its $3.0 billion 2019 capital spending program, which has historically been funded with equity. By using its retained cash flows, we believe this is achievable, further differentiating it from peers.

Cenovus Energy


Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $16 (CAD 21)

Fair Value Uncertainty: Very High

5-Star Price: $8 (CAD 10.50)

Cenovus Energy represents one of our Best Ideas for investors in the Canadian energy sector. The stock is currently trading around a 60% discount to our fair value estimate, while on average the industry looks fairly valued. We believe the market is overlooking the immense growth potential in the company's oil sands reserves that can be brought on line with low-cost solvent-aided process technology. Consequently, we believe that the stock presents an attractive opportunity for long-term investors. Investors appear to be skeptical that the company can improve its balance sheet and undertake economic growth. We believe the company can bring on its production at under $50 per barrel WTI with its solvent-assisted technology.

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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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