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Quarter-End Insights

Energy: Supply Glut Continues, but Some Respite on Pricing

The glut in crude supply will take several more quarters to work through.

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  • Declining U.S. oil production over the next several quarters will help reduce global oversupply, but that alone won't fix the imbalance before 2017.
  • Reduced investment will eventually translate to stronger output declines and help markets rebalance.
  • Energy sector valuations are a bit frothy at current levels.

 

The most pressing question on the minds of energy investors: How long will it take for the industry to work through the current period of oversupply and rebalance itself? The answer: Not anytime soon. Current supply imbalances are such that oil production as of today is effectively running two years ahead of demand.

Thanks to ongoing productivity improvements, cost reductions, and slowing decline rates, U.S. shale's cost-competitive growth potential is much greater than the market currently realizes. U.S. tight oil has fundamentally altered the global supply picture, ensuring the industry has more low-cost resources to develop than it will need. Instead of a return to high long-term prices, the industry needs to find the oil price that can keep a lid on U.S. shale activity, which we think will be $60 per barrel Brent. 

Declining U.S. oil production over the next several quarters will help reduce global oversupply, but in our opinion, that alone cannot quickly fix the current global imbalances. For the market to approach any semblance of normalcy before 2017--and likely for prices to respond accordingly--requires one or more of the following:

  • Saudi Arabia reverses course from its approach of maintaining market share at all costs and cuts production
  • global demand surprises to the upside from current expectations of 95 million barrels a day in 2016 and 95.9 mmb/d in 2017, or
  • a geopolitical event occurs (for example, political upheaval in Venezuela or another oil-exporting nation)

Without one or more of these occurring, "lower for longer" looks to be the unavoidable near-term course for the industry.

The potential for a significant amount of resources to become economically stranded is likely to foster continued pressure to drive down development and operating costs across the industry. This will result in cost compression at the marginal part of the cost curve, so that higher-quality oil sands and offshore projects can compete head-to-head with U.S. shale. These areas of the industry don't have a choice; otherwise, U.S. shale will produce them right off the map.

We continue to believe upstream capital spending in the United States will fall sharply in 2016 for the second consecutive year as producers struggle to align budgets with cash flows. Reduced investment will translate to stronger output declines, and while it won't happen overnight, this will eventually help markets rebalance.

Sharp curtailments in oil-directed drilling activity could reduce U.S. natural gas production growth in the near term, but the wealth of low-cost inventory in areas like the Marcellus and Utica ultimately points to continued growth through the end of this decade and beyond.

Based on a more optimistic outlook for low-cost production--primarily as a result of slowing declines in associated gas volumes, as well as improved productivity and resource potential from the Marcellus and Utica--we recently lowered our long-term marginal cost for U.S. natural gas to $3 per thousand cubic feet from $4/mcf. We see more and more evidence that U.S. shale producers can survive (and in a few cases thrive) at much lower prices than we previously assumed.

With an overall price/fair value estimate of 1.25, we view energy sector valuations as frothy at current levels, but we do think the names below are worth further investigation from investors.

Top Picks

 Chevron (CVX)
Star Rating: 3 Stars
Economic Moat: Narrow
Fair Value Estimate: $95.00
Fair Value Uncertainty: Medium
Consider Buying: $66.50 

Chevron remains our preferred play in the integrated space, given its greater leverage to an oil price recovery and superior production growth, which should drive greater earnings growth over the next several years. The completion of new projects and the accompanying reduction in capital expenditures mean the firm's cash flow break-even oil price will fall during the next several years, ensuring the dividend and eventually allowing for growth. Its valuation is the most compelling of the group as well.

 HollyFrontier (HFC)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $47.00
Fair Value Uncertainty: High
Consider Buying: $28.20 

HollyFrontier operates high-quality refining assets that are advantageously located solely in the midcontinent and typically deliver high returns. However, current market conditions, specifically weak gasoline margins and narrow light crude differentials, have reduced earnings and prompted a sell-off in the shares. As a result, the current share price is now overly discounting long-term earnings potential and the probability spreads widen. A solid balance sheet and strong cash flow keeps the dividend safe and should allow management to fulfill its commitment to repurchase shares.

 Magellan Midstream Partners (MMP)
Star Rating: 3 Stars
Economic Moat: Wide
Fair Value Estimate: $76.00
Fair Value Uncertainty: Low 
Consider Buying: $60.80

With its portfolio of great assets, we continue to view Magellan Midstream as one of the more attractive names in the midstream sector. The firm benefits from a conservative business run by a stellar management team. Magellan is primarily a fee-based business, with margins generated by low-risk transportation- and storage-related activities, which constitute 85% of total operating profits. Below-average commodity exposure cushions Magellan somewhat from volatile swings in commodity prices. Magellan also possesses a strong balance sheet and solid coverage ratio that provide it with a cushion during periods of commodity and economic volatility. This will allow the firm to raise its cash distributions by a minimum of 10% in 2016.

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