Where We See Opportunity in the Oil Price Slide
OPEC's decision to maintain production quotas has sent oil prices lower and created a number of good opportunities to buy quality businesses.
A broad range of energy stocks took a battering in the aftermath of OPEC's Thanksgiving Day meeting, opening up opportunities to buy some high-quality franchises at a discount.
We doubt that consensus among member countries was achieved at the meeting, but the 30 mbbl/d target output was maintained anyway, dashing any lingering hope that the cartel would defend a higher price level by removing supply.
By our estimates, oil markets are oversupplied by roughly 1 million barrels a day, which may increase into early 2015 absent a production response. But the supply surge from U.S. shale oil has been well anticipated by markets, leaving us to wonder what has changed fundamentally in the market's awareness that has dropped the energy sector by 20% since Sept. 1. Over the medium term, we continue to believe that lower crude prices will stimulate demand, supporting our expectation of higher prices in the future. However, we caution that further near-term demand weakness could spark another leg down in oil markets before any recovery takes hold.
Morningstar's price deck is composed of three years of current crude-oil strip pricing followed by our midcycle price estimate of $90/bbl, which we still believe reflects the marginal cost of North American shale production. If prices become entrenched near the current level, producers will curtail activity and high base declines will truncate North American production fairly quickly, restoring the global supply-demand equilibrium and boosting prices. Below is our take on the impact on several industries within the energy sector and our favorite opportunities in each. Premium Members can click here to see a list of all firms in the energy sector that are currently rated 4 or 5 stars.
We think the market reaction among midstream firms in particular has been overdone. While some U.S. MLPs do have modest exposure to direct crude-oil or natural gas liquids prices, the vast majority of cash flows are linked to long-term, fee-based contracts, supporting relatively stable cash flows despite market tumult. Moreover, midstream firms create value by building new assets. Despite low oil prices, we continue to see robust project pipelines from firms in our coverage universe.
We view the current pullback in stock prices as a good opportunity to buy quality franchises at a discount. Wide-moat MLPs such as ONEOK Partners (OKS), Williams Partners (WPZ), and Enterprise Products Partners (EPD) look compelling currently, as do large-cap midstream corporations Spectra Energy (SE), Williams (WMB), and Enbridge (ENB).
Integrated Oil Majors
While we plan to update our fair value estimates to reflect current crude-oil strip prices, reductions should be modest for the oil majors. We think the market reaction among integrated firms has been overdone based on our long-term outlook. The integrated group is generally more insulated from oil price movements because of their large gas production and downstream operations, which can act as an earnings offset. Also, we do not think dividends from the higher-quality firms will come under threat thanks to relatively strong balance sheets and managements' aversion to cuts. ExxonMobil (XOM) and BP (BP) are our preferred plays, given valuation and greater free cash flow growth relative to peers.
The current pullback in E&P stock prices has created some good opportunities. In particular, among oily stocks we like Apache (APA), Concho (CXO), Devon (DVN), and Pioneer (PXD), given their generally low-cost models, strong balance sheets, and meaningful discounts compared with our estimates of intrinsic value.
While we are updating our fair value estimates to reflect current crude-oil strip pricing, we think the market reaction among certain offshore drilling firms has been overdone. The makeup of rig fleets, leverage, and the risk of idle rigs as contracts roll over must be carefully considered in the current environment. While all the offshore drillers we cover are currently trading at a discount to our fair value estimates, we prefer Ensco (ESV), based on its management quality and strong customer relationships, and Rowan (RDC), for its fleet of four brand-new ultra-deep-water drillships, which were all contracted at day rates well above what the market is now providing.
For oilfield services companies, there will be a near-term impact to revenue and earnings as near-term activity levels recede. While the majority of 2015 capital budgets have not been announced, the oil producers that have given spending guidance on the whole are planning to meaningfully dial back investment.
But given our expectation that this will be a temporary pullback, we view the recent sell-off as a good opportunity to buy quality franchises at an attractive price. Specifically, we consider wide-moat names Schlumberger (SLB) and National Oilwell Varco (NOV) as best positioned to weather a downturn, as well as companies like FMC Technologies (FTI), Cameron (CAM), and Technip (TEC), which have large order backlogs that will support revenue and earnings in 2015.
Chinese Oil Majors
While we plan to update our fair value estimates for the Chinese oil majors to reflect current crude-oil strip prices, reductions should be modest as this group is more insulated from oil price movements given the large amount of gas production and downstream operations that can act as an earnings offset. As a result, we think the market reaction among Chinese oil majors has been overdone. While PetroChina (PTR) and Sinopec (SHI) face visible margin pressure given their higher production costs (between $65 and $75 per barrel), further declines in stock prices will open up attractive opportunities in shares of narrow-moat CNOOC (CEO).
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