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Coming Shale Growth a Major Threat to Oil Prices

Rapid U.S. production growth is looming.

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OPEC’s production cuts and strong demand growth have 2017 crude fundamentals in their best shape since oil prices crashed two years ago. The consensus outlook is that fundamentals are now strong enough to remain healthy even after OPEC’s cuts lapse. This might have been possible a few months ago, but the odds of this scenario playing out have markedly worsened since. The reason is that major increases in shale activity now have U.S. production firmly on a path of rapid growth, even if rig counts don’t increase further. This growth plus the eventual supply increases from OPEC is likely to be more than enough to erase any market tightness and throw crude markets back into oversupply.

What’s obvious by now is that current oil prices provide economics that are very attractive to the major U.S. shale producers. This has created the conditions that will allow tight oil to grow rapidly and is a reality that even looming cost inflation will not change. Unless shale producers become more disciplined or OPEC resigns itself to permanently ceding share to the United States--neither of which is likely to occur--oil markets have major problems looming.

There does remain a good chance that oil prices could rise in the coming months if OPEC compliance remains high or production cuts are extended. Because surging shale output won’t truly begin to move the supply needle until the second half of the year, these would allow for further inventory draws. This could bolster the perception that oil market fundamentals are improving. In reality, oil prices above current levels at any point in the coming months would in fact be pouring gasoline on the flames, since it would encourage even higher levels of U.S. shale investment. Nothing is certain in the world of oil, but clouds appear to be gathering on the horizon. We our maintaining our forecast for strong oil prices in 2017, with West Texas Intermediate averaging $58 per barrel, followed by a meaningful pullback to $45 in 2018.

Undervalued Names Are Few and Far Between
With the consensus on oil prices much more bullish than Morningstar, it’s unsurprising that we see only a handful of undervalued names in our oil and gas coverage today. We continue to view the U.S. refining and midstream sectors as the most attractive areas of oil and gas. These firms benefit from U.S. shale growth while bearing meaningfully less downside risk if future oil prices wind up being lower than current consensus expectations. In our coverage, we see the most value today in refining, particularly  HollyFrontier (HFC) and  Marathon Petroleum (MPC). In our upstream coverage, we believe  RSP Permian (RSPP) and Canadian integrated  Husky Energy (HUSKF) are the most attractive at current prices.

HollyFrontier operates a high-quality set of refining assets located solely in the midcontinent, Rockies, and Southwest regions. It’s currently suffering from weak product margins, narrow crude spreads, and high renewable fuel supply costs. While we do not expect these poor conditions to persist, the market appears to be discounting a continuation for several years. Furthermore, we think the market is not giving full credit for Holly’s 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.

Marathon Petroleum’s existing refining asset base is well positioned to capitalize on the ever-changing domestic crude market. The company is also investing to expand its midstream and retail businesses to diversify its earnings stream away from the more volatile refining business. Longer term, the outlook for Marathon is bright, as the firm will benefit from the continued growth of tight oil and shale gas in the U.S.

RSP Permian is a very lean company that operates exclusively in the Permian Basin, which is widely considered to be one of the lowest-cost tight oil plays in North America. Though the entire industry is focusing on cutting costs and enhancing efficiency, RSP is well ahead of the curve. Operating expenses, including exploration and general and administrative, add up to less than $12 per barrel of oil equivalent, and the cost of finding and development is around $20/bbl. That translates to a WTI break-even of just under $40/bbl, well below midcycle.

These competitive economics look sustainable. The firm recently doubled its Permian footprint with the acquisition of Silver Hill Energy Partners, gaining entry to the Delaware side of the basin (which is at least as profitable as the Midland, where RSP’s core acreage is located, if not more so). As a result, the firm has several decades of cost-advantaged runway. We forecast a 50% compound annual growth rate in production through 2020.

Husky Energy remains our top Canadian integrated pick. While Husky is in less of a position to benefit from advanced extraction technologies, we believe that the market is unjustly punishing the company for its intended lack of large-scale growth and suspension of dividends while overlooking Husky’s ability to generate free cash flow in low-oil-price environments. Husky’s downstream and midstream operations should not be overlooked, accounting for about 30% of EBITDA. In addition, Husky’s integrated operations help mitigate market volatility by generating cash flow when commodity prices are low.

The company continues its strategic transition toward low-sustaining-capital production, with sustaining capital costs approximating CAD 6/bbl. We expect production from low-sustaining-capital projects, which includes oil sands production, to grow from 8% of total production in 2010 to approximately 45% by the end of 2017. Improved efficiency on oil sands production affords the company break-even prices of sub-$35/bbl Brent (excluding overhead costs) at current production levels, which compares favorably with peers.

Additionally, concerns about natural gas production in China appear overstated, despite causing repeated meaningful share price moves. Although Husky came to a favorable agreement with CNOOC over price realizations for its Chinese production, there remain concerns that CNOOC will attempt to renegotiate if low prices persist. Whatever transpires, natural gas production from China represents only 7% of Husky’s total production, and additional price declines will not have a significant impact on the company’s value. Furthermore, free cash flow growth holds the opportunity for reinstatement of the dividend.

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