Game Change: Low-Cost U.S. Oil Is Here to Stay
Oil prices are likely to rebound from here, but robust U.S. supply will ultimately cap upside.
Given its remaining growth potential and ability to quickly scale activity up and down, tight oil has effectively made the United States the world's newest swing producer. Drastic spending cuts will lead to a meaningful decline in near-term production, but the strong economics of the major U.S. liquids plays mean production will again begin growing as soon as oil prices recover. Based on our belief that U.S. unconventionals will continue to be able to meet 35%-40% of incremental new supply requirements in the coming years, we believe additional volumes from high-cost resources such as oil sands mining and marginal deep-water will not be needed for the foreseeable future. This disruptive force that already has upended global crude markets isn't going away anytime soon. U.S. shale once again is proving to truly be a game changer.
Despite our belief that tight oil has considerable running room from here, it can't completely meet future global demand. The marginal barrel therefore will come from higher up the global cost curve. Our forecasts show higher-quality deep-water projects will be the highest cost source of supply needed during the rest of the decade. As a result, we are lowering our Brent midcycle oil price forecast to $75 a barrel (West Texas Intermediate $69/bbl).
We nonetheless believe a handful of undervalued, advantaged firms can ride out the weak market dynamics facing the energy sector. Among upstream producers, we recommend ExxonMobil (XOM), Cabot Oil & Gas (COG), Chesapeake Energy (CHK), and Encana (ECA). In services, the pending merger with Baker Hughes positions Halliburton (HAL) to become the U.S. oil services juggernaut. The clear winner in energy is midstream, as robust U.S. supply growth will provide growth opportunities. Spectra Energy (SE) and Spectra Energy Partners (SEP) are our top picks, while oil-leveraged Magellan Midstream Partners (MMP) is one of the more conservatively run master limited partnerships in the sector and a potential refuge for risk-averse energy investors.
U.S. Unconventionals Growth Upends Global Crude Markets
The U.S. has rapidly become the critical source of incremental supply for global oil markets, and growth has come overwhelmingly from unconventionals. In recent years, liquids from U.S. shale plays accounted for almost 40% of incremental global production, as the strong economics attracted huge amounts of capital.
For many years, the large increases in U.S. output did not upset supply/demand balances, largely because significant amounts of supply were disrupted by political or security issues (for example, Libya, Iran). But in 2014, the scales finally tipped: With weakening demand and OPEC's decision not to reduce its own production, major supply imbalances resulted that have yet to dissipate.
While the robust growth of U.S. unconventionals is the single-largest reason oil markets are so oversupplied, we expect it also to act as one of the critical factors that lead to an eventual rebalancing. Responding to low prices, exploration and production firms have significantly dialed back spending in the past few months. As a result, U.S. production not only is about to stop growing in the short term, but will begin to decline within the next few months.
One key indicator of near-term production levels is active rig counts, and this has dropped 38% in the past six months. We expect more rigs to be taken off line in the coming months before rigs trough at almost 50% below 2014 highs. With drilling activity unlikely to pick up until the end of this year, we currently forecast U.S. liquids production to fall by more than 1 million barrels a day between today and mid-2016 , essentially removing the necessary amount of supply required to balance the market. Given this ability to quickly ramp production up or down, the U.S. has effectively become the world's newest swing producer, replacing OPEC in the role the latter recently chose to vacate.
The implications of this are significant, and suggest that U.S. production levels will be very responsive to market conditions and future oil price expectations. Our current forecasts show global supply and demand will sufficiently rebalance over the next few quarters, which arguably supports the current $60-$65/bbl WTI strip prices. Such price levels are sufficient to begin encouraging higher levels of investment, which in turn would lead to the resumption of production growth. There are limits to how much incremental supply U.S. producers can provide, but given the strong economics of U.S. unconventionals and our midcycle price outlook, we think it's very reasonable to expect that overall U.S. production will be 20%-30% higher at the end of the decade than it is today.
Cost Deflation Will Eventually Provide Uplift to Challenged Economics
In the current situation of high costs and low oil prices, upstream firms face extremely challenged economics where new investment does not create value. Such conditions are not sustainable over the long term, and we expect the combination of rising oil prices and falling costs to provide significant relief in the coming years. Our expectation is that capital and services costs will significantly deflate in the short term to encourage new investment (a trend that is already well underway). We expect short-term capital cost reductions to reach 30% for U.S. onshore and 10%-20% for international projects.
While there is a cyclical element to capital cost deflation that will reverse when industry fundamentals improve, our expectation is the capital cost levels will not again approach 2014 levels this decade. There is simply too much low-cost supply that can be brought on line to allow oil prices to reach the levels that support previous capital intensity levels. We expect midcycle costs will remain 20% below recent levels for U.S. onshore producers and 10% for international projects.
Based on our capital cost outlook, we estimate that the big three tight oil plays (Eagle Ford, Permian, and Bakken) will be able to generate 10% aftertax returns at oil prices between $50 and $60 per barrel. Compared with the marginal sources of oil supply, this is a significant cost advantage that is sure to encourage development in the coming years. Even if U.S. onshore capital costs inflate all the way back to 2014 levels, the major unconventionals plays that underpin our bullish U.S. supply outlook would all still be economic at prices between $60 and $70.
Midcycle Implications: Marginal Barrel Is Not at High End of Global Cost Curve
For 2019 and 2020, our global supply/demand forecasts imply that roughly 6 mmb/d of new production will be needed each year to meet future demand. Based on our belief that U.S. unconventionals will be able to meet 35%-40% of incremental new supply requirements at very competitive costs, we believe the marginal barrel for global oil is not currently at the highest point of the global cost curve. In other words, the superior economics of U.S. shale have effectively crowded out marginal sources of supply such as oil sands mining and high-cost deep-water (for example, the North Sea) .
That said, far more new supply is needed besides U.S. unconventionals to meet future global demand, so marginal supply will come from a resource higher up the global cost curve. Our forecasts show higher-quality deep-water projects (for example, the Gulf of Mexico and the strongest projects in West Africa) will be the highest-cost source of supply needed during the rest of the decade. As a result of this meaningful shift in our long-term supply outlook, we have reduced our Brent midcycle oil price forecast to $75/bbl (WTI $69/bbl).
Concurrent with our midcycle price update, we have also revised our forecast for North American crude differentials. Previously, our long-term estimates for the per-barrel WTI/Brent and Light Louisiana Sweet/Brent differentials were $10 and $4, respectively. These differentials were derived from estimated transportation costs necessary to ensure movements of Bakken crude by rail to refining centers on the East and West coasts. However, we have recently witnessed significant investment in infrastructure that has lowered transportation costs, which narrows our midcycle differentials estimates. Our updated forecasts call for WTI/Brent and LLS/Brent of $6 and $2, respectively.
Uncovering Value in a Lower Price Environment
Our oil midcycle updates coincide with lowering our U.S. natural gas midcycle price to $4/mcf. Valuation impacts from our commodity price updates vary by both subsector and company, but the most meaningful reductions are being borne by upstream producers (E&Ps and integrateds) and services firms.
Even with our lower price forecasts, however, there remain a handful of undervalued, competitively advantaged firms that we believe can ride out the currently weak market dynamics facing global oil and U.S. natural gas and that represent attractive opportunities for longer-term investors.
In the current situation of high costs/low oil prices, upstream firms face extremely challenged economics where new investment does create value. Such conditions, in our view, are not sustainable over the long term, and we expect the combination of rising prices and falling costs to provide significant relief in the coming years. Our expectation is that capital and services costs will significantly deflate in the short term to encourage new investment.
Oil-focused E&Ps: Encana (ECA) is our top pick in this group. Growth is underpinned by high-quality Permian and Eagle Ford acreage, and the firm possesses a rock-solid balance sheet. We also believe Permian-focused Laredo Petroleum (LPI) is trading at attractive levels despite its high-quality acreage base.
Oil majors: We view ExxonMobil (XOM) as offering the best combination of value, quality, and defensiveness. Among the high-dividend-yield but lower-quality European integrateds, BP (BP) remains the most attractive.
Our view remains that the best services firms continue to drive a lot of the innovation and key technology, and they thus will continue to capture economic rents. The fact that industry profits will be lower in future years means the rent available to capture has shrunk compared with our previous midcycle assumptions. However, capital costs will eventually start to reflate after the industry bottoms, and thus a cyclical recovery will eventually occur to reach our midcycle forecasts.
The companies most likely to struggle will be those most leveraged to deep-water, given that higher-cost projects lack sufficiently strong economics to progress.
Integrated services: Despite our expectation of onshore U.S. capital costs being 20% lower in 2019 versus last year, we believe the big four will nonetheless be able to stage a recovery following a painful 2015. Deep cuts to labor and operating costs should provide these firms with their own cost relief. We see robust U.S. unconventionals activity supporting consistently growing revenue once the industry is more in balance.
Our top pick is Halliburton (HAL); its existing exposure to North America and pending merger with Baker Hughes position the firm to become the U.S. oil services juggernaut. One wild card is whether the combined firm will have to sell off portions of its business for antitrust concerns (we discount the value of the merger by 40% to account for this risk).
Midstream is the clear winner of our more bullish U.S. outlook. Predominantly fee-based cash flows insulate midstream firms from commodity price fluctuations, and our forecast for U.S. unconventional production growth will require more infrastructure through the end of the decade than we had previously anticipated. This secures the midstream growth story for several more years, providing greater visibility on investment levels after the current slate of projects enter service.
Spectra Energy (SE) and Spectra Energy Partners (SEP) stand out as our top midstream picks and are supported by $7.5 billion in pipeline projects through 2019, primarily focused on providing takeaway capacity for the Marcellus.
Magellan Midstream Partners (MMP) is our favored oil-leveraged MLP, given its robust distribution growth and excess coverage and solid pipeline of growth projects. Magellan is one of the more conservatively run MLPs in the sector and a potential refuge for risk-averse energy investors.
Despite our forecast for narrower long-term North American differentials, we still hold a positive view on the refining sector as its feedstock advantage remains intact. A key premise behind our lower oil price assumption is the increasing competitiveness and growth of U.S. tight oil production, which should in turn lead to greater supply of lower-cost, high-quality feedstock for U.S. refiners. Additionally, U.S. production growth should create additional infrastructure investment opportunities for refiners to expand their master limited partnerships. Furthermore, our assumption of lower natural gas prices means U.S. refiners will continue to enjoy an operating cost advantage. Consequently, we expect refiners to maintain their low-cost position in the global market, ensuring returns on capital and therefore their narrow moat ratings.
Among our refining coverage, we see Tesoro (TSO) and Phillips 66 (PSX) as undervalued firms best positioned to capitalize on continued U.S. feedstock cost advantages. Both also will be able expand their MLPs and drive earnings growth that does not depend solely on improved market conditions.
Stephen Simko does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.