Energy: OPEC Adds a Plot Twist, but Ending Is Unchanged
Improved near-term fundamentals come at a cost.
Improved near-term fundamentals come at a cost.
OPEC's recently announced production cuts represent a positive near-term development for world oil markets, removing more than 1 million barrels per day from an oversupplied system. 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. Consequently, we are raising our 2017 West Texas Intermediate price to $60 per barrel from $50.
Improved near-term fundamentals come at a cost, however. Even a modest recovery in oil prices will encourage U.S. shale producers to further ramp activity so that they eventually replace almost all "removed" OPEC barrels with their own. Increased near-term shale activity means that oil prices are unlikely to remain elevated for long. The industry is awash in low-cost oil, and temporary OPEC cuts cannot alter this reality. Our long-term oil price assumption of $55/bbl WTI is unchanged.
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 are reiterating our long-term marginal cost for U.S. natural gas of $3 per thousand cubic feet. 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.
We view energy sector valuations as frothy at current levels, but we do think the names below are worth further investigation from investors.
Tesoro (TSO)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $124
Fair Value Uncertainty: High
Five-Star Price: $74.40
We see Tesoro's competitive position improving over the next several years as the firm gains greater access to cost-advantaged crude. Given this, combined with operational improvements including increasing distillate yields, integrating the acquired Carson refinery, and leveraging its marketing and retail operations, Tesoro should become one of the better-positioned refiners in the challenging California market. Meanwhile, the acquisition of Western Refining diversifies its refining asset base, further strengthens its retail network and adds additional midstream growth opportunities in the Permian Basin for a reasonable price.
HollyFrontier (HFC)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $44.00
Fair Value Uncertainty: High
Five-Star Price: $26.40
HollyFrontier operates a high-quality set of refining assets located solely in the Midcontinent, Rockies, and Southwest regions. Currently, it's suffering from weak product margins, narrow crude spreads, and high renewable fuel supply costs. Although we do not expect these poor conditions to persist, the market appears to be discounting a continuation for several years. Furthermore, we think it is not fully crediting Holly with its self-improvement initiatives. As a result, we think the shares are significantly undervalued. We expect product margins to improve with continued strong demand and a rebalancing of inventories. Meanwhile, crude spreads should widen with future U.S. production growth. Renewable fuel supply costs are likely to persist into 2017, but a new administration increases the probability of reform that ultimately reduces compliance costs. At a price/fair value estimate of 0.70, the current stock price offers an attractive entry point for long-term investors.
Antero Resources (AR)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $32
Fair Value Uncertainty: Medium
Five-Star Price: $22.40
Antero Resources is the most active driller in the Appalachia region (Marcellus and Utica plays). We believe it is also one of the most attractively priced. The stock currently trades at a 25% discount to our fair value estimate. Although natural gas still constitutes around 75% of the firm's production, a substantial portion of its acreage is situated in areas with a fairly high liquids content, differentiating the company from its peers that are predominantly targeting dry gas.
The profitability of Antero's inventory continues to trend higher. Drilling and completion costs have declined steadily over the past two years in the Marcellus and Utica plays, and there is scope for further efficiency gains that could lower costs further. Meanwhile, the productivity of Antero's wells is likely to increase across the portfolio, due to the widespread adoption of high-intensity completions (using at least 1,300 pounds per foot of proppant). Finally, despite perennially weak natural gas prices in the Appalachia region, Antero's extensive firm transport and sales portfolio is enabling it to sell the majority of its production at premium, out-of-basin prices (the firm's realized third-quarter natural gas price was $0.05 above Henry Hub).
More Quarter-End Insights
Market Outlook: New Expectations Set the Tone for 2017
Economic Outlook: More of the Same Anemic Growth
Credit Insights: Global Rates on the Rise
Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation
Consumer Cyclical: Poised (and Priced) for a Strong 2017
Consumer Defensive: Cooking Up a Bit More Value
Financials: What Will Really Drive Interest Rates?
Healthcare: What Does a Trump Administration Mean for Healthcare Stocks?
Industrials: Baking In Too Much Optimism
Real Estate: Through the Noise, Opportunities Exist
Joe Gemino does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.