Energy Retreats, Offering Some Opportunities

For the first time this year, the Morningstar US Energy Index retreated against the overall market in the third quarter, finishing flat against the market’s 3.24% improvement. Surges in the number of COVID delta variant cases continue to present demand risks to energy markets, while planned OPEC supply additions and continued U.S. shale expansion are starting to present a threat on the supply side. With the recent decline in the third quarter, we view energy as slightly undervalued, with the average stock trading at a 6% discount. Opportunities exist across all segments, particularly services, integrated, and exploration and production, which trade at discounts of 31%, 12%, and 3%, respectively.

Exhibit 1: Still outperforming year to date, despite quarterly retraction.

- source: Morningstar

While the delta variant has reintroduced concerns about lockdowns, we do not expect significant further disruption to mobility—and that limits the downside for oil demand. Vehicle miles traveled has largely recovered, along with consumption of petroleum products like gasoline and diesel. Jet fuel is the sole laggard, and there are positive data points emerging on that front, too (most notably the U.S. announcement that vaccinated foreigners will be admitted in November). As a result, we think the recovery in consumption will persist. Our demand estimates for 2021 and 2022 are 96.2 million and 100.4 million barrels per day, respectively.

Exhibit 2: The oil-services and midstream segments offer the best value in energy.

- source: Morningstar

Nevertheless, we think oil prices are frothy at the current level, and there is no change to our $55/bbl midcycle forecast for West Texas Intermediate crude. In its Sept. 1 meeting, OPEC reaffirmed its plan to ratchet output monthly by 400 thousand barrels per day through 2022, effectively unwinding all voluntary curtailments. The cartel added back over 600 mb/d in July, led by Saudi Arabia’s addition of 500 mb/d. Meanwhile, U.S. shale volumes leapt to 8 mmb/d in the second quarter, led predominantly by private firms.

Exhibit 3: Global oil demand to exceed prepandemic level in 2022.

- source: Morningstar

While shareholders of publicly traded E&P firms have prioritized returns and capital discipline, private firms have been able to adjust output in response to price. From pandemic lows, private firms have increased rig activity 85% compared with public E&Ps 50%. Consequently, the total rig count now exceeds the equilibrium level, and further growth could even tip the market back to oversupply. Our updated supply estimates are 94.8 mmb/d and 100.9 mmb/d for 2021 and 2022, respectively.

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Schlumberger SLB Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $47 Fair Value Uncertainty: Narrow

Although rallying share prices have removed much of our oilfield-services coverage from deeply undervalued territory, investors can still get industry leader Schlumberger for a bargain. We expect industry activity to recover from COVID-19, with long-run activity in international markets (where Schlumberger focuses) even surpassing prepandemic levels. We think Schlumberger will continue its historical record of leading peers in technological progress and generating high returns on capital.

Exxon Mobil XOM Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $74 Fair Value Uncertainty: High

Although Exxon management responded to shareholder concerns and pulled the reins on its once-aggressive investment plan, an activist still won board seats. Management will surely have to make some changes as a result, but we do not see a wholesale change in strategy. As such, Exxon remains a Best Idea, given that it holds one of the more attractive investment opportunity sets, with high-quality assets in Guyana and the Permian and should benefit from improved refining market conditions.

Pioneer Natural Resources PXD Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $197 Fair Value Uncertainty: Medium

Historically one of the shale industry's more profligate capital allocators, Pioneer is now a poster child for capital discipline and intends to reinvest only 50%-60% of cash flows (still enough to keep output growing at 5% annually). Much of the remainder will be redistributed to shareholders via a variable dividend that will keep payouts calibrated with the commodity cycle, setting an example all peers should follow. Its zero-basis Midland Basin acreage contains enough top-tier drilling opportunities to support decades of high-margin drilling.