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Quarter-End Insights

Energy: Stocks, Oil Prices Have Rebounded, but Some Opportunities Remain

We see less value in oil stocks than we did earlier this year.

The Morningstar Global Energy Index has rebounded along with broader equity markets since the beginning of 2019. The Energy Index is up 14% year to date through March 25 compared with an 11% gain in the Morningstar Global Equity Index. Rising oil prices, up roughly 29% since the end of 2018 have fueled the strength in energy stocks.

Global energy index vs. global equity index - source: Morningstar Analysts

With oil prices once again above our unchanged midcycle price of $55 per barrel, we see less value in oil-related stocks than we did at the beginning of the year. Back on Dec. 31, 2018, the median price/fair value in our global energy coverage was 0.77. As of March 25, 2019, that same measure has risen to 0.89. To be sure, we still see value in the energy space, but less so than at the beginning of the year. Less than 2% of our energy coverage trades in 5-star territory compared with just more than 3% of our global Morningstar coverage.

Energy star rating distribution for sector and by key industry - source: Morningstar Analysts

For oil globally, we expect the tug of war between OPEC and U.S. shale producers to continue. Amid the drop in crude prices that started in 2018, OPEC and its partners have rededicated to constraining supply after a brief period of turning the spigots back on in mid-2018. Additionally, low supply from Iran, because of sanctions, and Venezuela, because of political unrest, has further tightened global markets. Amid the backdrop of cuts from OPEC, U.S. shale producers have dialed back somewhat as well due to falling oil prices, but rig counts in the major U.S. shale basins have not declined dramatically, and many U.S. producers say they expect continued growth in 2019. We think the most recent round of OPEC cuts only nudges the door open for shale producers to increase production and keep taking share from OPEC and its partners.

Our long-term oil price forecast is above current prices - source: Morningstar Analysts

We see $55 as the fully loaded cost for the marginal barrel of oil that will balance global supply and demand in the long run. We expect this marginal barrel to come from a U.S. shale well. Shale wells today are much cheaper per barrel than the large, complex megaprojects that would have set prices in a world without U.S. shale. Over the long run, we think U.S. shale well cost inflation will fall short of consensus, owing greatly to the no-moat nature of many shale services, and that wider adoption of current technologies coupled with decades of attractive drilling opportunities will contain unit break-evens.

Decades of attractive shale drilling opportunities remain - source: Morningstar Analysts

Top Picks
 Enbridge (ENB)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $47
Fair Value Uncertainty: Medium

Wide-moat Enbridge represents our Best Idea for investors in the Canadian midstream sector. We see 25% upside in the stock, while on average the Canadian midstream sector looks fairly valued. We believe the market doesn't realize the full potential of the company's growth portfolio, which is highlighted by the Line 3 replacement project (Canadian Mainline pipeline expansion), approved in June 2018. Accordingly, we expect Enbridge to generate significant free cash flow, allowing it to increase its dividend at approximately 10% in 2020 and 3% thereafter. The company is currently yielding approximately 6%.

 Enterprise Products Partners (EPD)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $35.50
Fair Value Uncertainty: Low

We think investors do not appreciate Enterprise’s leading position as the exporter of incremental hydrocarbon, whether liquefied petroleum gas, oil, or ethane. We expect NGL production and exports to sharply exceed consensus U.S. NGL production estimates, which imply that the U.S. cannot supply enough ethane to meet the $150 billion-plus steam cracker expansion underway, and U.S. NGL exports will actually decline from existing levels.

 Schlumberger (SLB)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $62
Fair Value Uncertainty: High

Schlumberger stands out as high-quality and favorably valued. The market seems to be underrating prospects for the SPM business, a fully integrated services model that aspires to deliver a sea change in oil and gas development costs. SPM is already delivering returns on capital far ahead of the rest of the company, and therefore the business will lift Schlumberger's profitability up as it grows as a share of revenue in years to come.

Jeffrey Stafford has a position in the following securities mentioned above: SLB. Find out about Morningstar’s editorial policies.