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Moaty Oil Stocks Worth a Second Look

Oil's drop has left some firms vulnerable without a competitive advantage, but other quality companies look undervalued today, says Morningstar's Allen Good.

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Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall, and I'm joined today by Allen Good, Senior Equity Analyst for Morningstar.

Hi, Allen.

Allen Good: Hello, how are you today?

Wall: Very well. Thank you. Oil, a big topic, very popular subject. You just gave your talk at the Morningstar Investment Conference Europe. Morningstar analysts have recently downgraded the oil price forecast. What price are we looking at now?

Good: Previously we were using $100 per barrel oil; now we're using $75. The basic reason behind that is because we think the potential of U.S. tight oil--its size, amount of production, and then ultimately its cost--mean that we can meet a lot of supply without having higher prices.

So, if we look at U.S. tight oil, most of it is viable below $60 per barrel. And the size of the resource is also much larger than we previously thought. So by 2020, we think we need about 6 million barrels per day; 40% of that can be met by tight oil and the remainder can be met by supplies under $75. So, ultimately, we don't think you need $100 per barrel oil anymore to meet global supply.

Wall: So this isn't so much about the fact that we've seen the Brent crude come down from $110 to $55 again this week following Janet Yellen's speech. It's more to do with forward-looking supply and demand?

Good: Absolutely. I would say the one key change that we've seen in the past year is OPEC's unwillingness to step in and cut supply in front of the market. They were losing market share to the U.S., and as opposed to cutting supplies, increasing prices, and effectively subsidising the U.S., they decided to let the oil market really be a market.

And as a result, you don't necessarily have that price forward that we historically had. So at the end of the day, it all comes down to supply and demand and cost of supply. And the fact is, that cost of supply is a lot cheaper than it used to be.

Wall: So looking then at equities, you are an equity analyst. Obviously, oil prices are going to have a big impact on oil stocks; it's going to affect the fair value estimate and the economic moat as well. How are these stocks faring now?

Good: Stocks actually and collectively haven't fared all that poorly. Oil prices are down about 50%, but if you look at couple of the indexes, they are only down 25%. Now, granted if you are a smaller player and you produce 100% oil, you are likely to be down 60% or 70%.

So we do think there is opportunity, even if you assume oil long-term at $75. Our preference is always for quality and valuation. We like firms that have low-cost assets, that can generate excess returns or, in Morningstar words, have an economic moat, and even have an economic moat at $75 per barrel of oil.

Now granted, not as many firms have economic moats at $75 oil as they did at $100. So we have reduced moat ratings for several of our E&P names and several of our integrated names, particularly the European major integrated oils: Shell, BP, and Total no longer have moats in our opinion.

What we are looking for are moaty names that are undervalued. And when we look across that screen, on the integrated side, we do see Exxon as a viable candidate. On the services side, we see Core Labs or Schlumberger. And then on the E&P side, we still think BG Group earns a narrow moat and even Tullow, which has had some difficulties, still has low-cost resource that is undervalued by the market.

Emma Wall does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.