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What Does the OPEC Deal Mean for Energy Stocks?

The agreement to cut oil production in 2017 has led to a runup in oil-related stocks that's unsustainable.

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The agreement among members of OPEC to cut oil production has pushed oil prices higher and encouraged U.S. producers to ramp up output.

OPEC members are expected to reduce supply by 1.2 million barrels, or more than 1% of global production, next year. The production cuts will last six months starting in January, with a possible six-month extension to be considered at OPEC's May 31 meeting. But as oil prices rise during the first half of 2017, U.S. shale producers will ramp up activity, making OPEC's cuts for the rest of the year less likely.

"Even after factoring in the inevitable U.S. shale response to higher crude prices, OPEC's cuts point to a meaningful supply deficit next year," says Morningstar equity research energy director Stephen Simko.

U.S. shale producers will take about six to nine months to start supplying the market once again, which should allow oil prices to stay elevated for most of next year. Thus, Morningstar has raised its 2017 West Texas Intermediate price forecast to $60 per barrel from $50.

Since OPEC's announcement in November to cut production to 32.7 million barrels per day, West Texas Intermediate crude has rallied more than 16% as of this writing.

What can investors expect from energy stocks next year, given the OPEC deal and recent rally in oil? And are there any opportunities in the sector today?

OPEC Deal: The Challenges
To achieve its goals, OPEC will need to persuade non-OPEC oil producers like Russia to cut output and to comply. And if history is any guide, during the past 20 years low production levels by the cartel members have lasted no more than a year, according to Simko.

OPEC's loss of market share to non-OPEC members--specifically, to U.S. shale producers--has been a major reason for the cartel's reluctance to cut production in previous years despite the continuous drop in oil prices since mid-2014.

That said, rig counts of horizontal drilling and hydraulic fracturing, or fracking, are up more than 54% since late May, according to Baker Hughes, mostly due to a rise in oil prices from around $30 a barrel to the current range of $50 a barrel.

"By itself, this increase in rig activity is sufficient to restart U.S. crude growth next year, and higher oil prices mean shale activity is all but certain to increase," Simko says.

The time it takes U.S. shale companies to drill and complete new wells is "no longer than six months," says Preston Caldwell, an analyst covering oil field services companies at Morningstar. "And if you want to rush it you can do it a bit quicker than that."

Simko estimates that U.S. shale oil production will ramp up to add 1.4 million barrels per day, offsetting the estimated OPEC cut of 1.2 million barrels per day, by the fourth quarter of 2018. 

"Thus, the faster uptick to $60 for oil merely brings more shale oil back into production sooner than expected," he said.

In addition, horizontal tight oil rig counts, including drilled but uncompleted wells, will reach 3,500 by the start of 2018, almost double recent trough levels, according to Simko.

Once U.S. shale is in full production, OPEC will likely unwind its production cuts, thereby allowing oil prices to drop. This will force shale producers to restrain overproduction or even cut activity, but the industry will be back to an oversupply scenario. As such, Morningstar has lowered its 2018 WTI forecast to $45 a barrel from $65.

"Increased near-term shale activity means that oil prices are unlikely to remain elevated for long," Simko says. "The industry is awash in low-cost oil, and temporary OPEC cuts cannot alter this reality."

Thus, Morningstar's long-term oil price assumption of $55 per barrel for WTI remains unchanged.

Are There Any Opportunities Left?
Bargains in this industry are few and far between: Morningstar considers the energy sector to be overpriced, trading at a 35% premium to its fair value estimate of the overall market as of this writing.

"We have been bearish in energy equities since at least April," Caldwell says. "In terms of the exploration and production companies, we think that they are priced at a level that seems to be implying a $10 per barrel higher of our long term oil price."

Energy companies are pricing WTI at $65 per barrel in the long term, while Morningstar forecast a $55 per barrel by 2020, a main reason the sector is overpriced by Morningstar's measures, Caldwell says.

"The recent run-up in energy related equities is irrational and has only added to our bearish case," Caldwell says.

As of this writing, only two oil-related companies are trading at 4 stars or better, suggesting that their shares are undervalued. 

 HollyFrontier (HFC), which currently trades in 4-star range, is an independent petroleum refiner. Though small, the company's refineries are well-positioned against their competitors, notes Morningstar analyst Allen Good in his latest report. The firm has all of its facilities in the U.S. midcontinent, Rockies, or Southwest region, allowing it to benefit from the recent difference in price between WTI and other crude such as Brent.

"While the spread is likely to remain narrow in the near term, we expect it to widen over the next five years," says Good. "The transportation costs to move light crude from the midcontinent to the Gulf Coast result in a long-term WTI differential to Brent of $5 per barrel, well above historical levels (before 2010)."

In addition, HollyFrontier has a system that "allows it to process heavy crude and produce comparable yields of refined product cheaper than refineries that use only the easier-to-refine but more expensive light crude."

 Tesoro (TSO), also in 4-star range, is an independent refiner and operator with its refining capacity concentrated largely in California. 

"As a result, it has not realized the benefit of the ongoing midcontinent discounts that many of its peers have," Good says in his latest report. The company does, however, have two midcontinent refiners that have benefited, including the only refinery in the Bakken region, he says.

"That said, past and future investments and the addition of infrastructure should allow Tesoro to capture about as much cost-advantaged feedstock as its peers, although the discounts may not be as wide," Good says.

Tesoro has invested to expand capacity at its two midcontinent refineries to process greater amounts of discount light crude. It has also invested in rail facilities, which has resulted in improved yield and margins. As such, Good expects the imbalance between light and heavy crude in the midcontinent will create an opportunity and economic incentive to rail both types of crude to its three California refineries, increasing their throughput of cost-advantaged crude.

"As a result, we see midcycle margins and returns on capital improving over the next five years," Good added. 

Manuela Badawy is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

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