With Oil Prices Tanking, We See Values
Nearly all the E&P and oil-services stocks we cover trade below what we think they're worth.
West Texas Intermediate crude oil has fallen from over $65 a barrel in late April to about $54/bbl today, a hair below our midcycle forecast of $55/bbl. The slump has dragged most exploration and production stocks down with it, with 22 of the 23 names we cover now trading below our fair value estimates. The median and mean discounts are 12% and 16%, respectively. The decline has pushed oilfield-services stocks into very cheap territory as well. The median oilfield-services company we cover is trading at a 20% discount to our fair value estimate.
The decline in crude prices has erased most of the E&P companies’ gains from earlier in the year, when fundamentals were supported by strong compliance with steep OPEC cuts. Indeed, OECD oil inventories plunged in February and March (the most recent months with reported data). Debottlenecking in the United States has since enabled shale producers to resume their rapid growth, however, while trade fears increasingly threaten to stymie demand. In May, the International Energy Agency reduced its 2019 growth forecast by 90 thousand barrels per day, just shy of the 100 mb/d impact that Rystad Energy attributes to the worst-case scenario where tariffs are applied to U.S. and China trade volumes. Meanwhile, U.S. inventories have surged in the last three months, culminating this week with a 17 thousand-barrel build--a contrast to the seasonal draw expected. OPEC is likely to extend the cuts when they expire in June, with or without Russian support. However, this won’t be enough to sustainably drive up prices beyond our midcycle forecast (as shale producers can compensate with higher activity levels during periodic upswings).
Nevertheless, we still think the E&P segment is undervalued. In the last few years, U.S. E&Ps have adjusted to generate free cash flows with WTI at $50-$55, and a handful--the narrow-moat-rated cost leaders with the juiciest acreage and the savviest technical teams--can generate excess returns on invested capital as well. Diamondback Energy (FANG) and Pioneer Natural Resources (PXD) fall into this bucket. Both operate exclusively in the Permian Basin, which is characterized by strong initial production rates and a favorable oil mix. These companies are among the largest independent operators in the basin, which helps with logistics in the field and enables them to extract favorable terms from midstream and service industry partners. At current prices, Diamondback is 23% undervalued and Pioneer is 17% undervalued.
Laredo Petroleum (LPI) is also a Permian Basin pure play, but the stock doesn’t have the same shine since the company’s acreage is less favorably located on the outer edge of the play (away from the traditional “sweet spot”). So it stands to reason that the market is more lukewarm on the name. However, due to fixable operating issues, the current discount is way overdone, in our view, making this one of the most compelling ideas in the upstream segment with over 100% upside. At this level, the stock bakes in no improvement in well performance whatsoever from 2018 levels, even though management has adjusted its strategy and has reverted to a wider spacing pattern (similar to what it used in 2016, when well performance was consistently better). In addition, we note that while meaningfully undervalued, Laredo has decent financial health, substantial downside protection via hedging, and can achieve 4% annual production growth within cash flows under midcycle conditions.
For oilfield-service companies, we think the market is pricing in overly pessimistic views on growth in oil and gas capital expenditures. We forecast a cumulative 20% growth in international capital expenditures through 2022 due to the long-term upward trend in development costs as well as the rectification of underinvestment by many oil producers currently. By contrast, the market is pricing in almost flat international capital expenditures.
Schlumberger (SLB) remains our top pick, trading at a 42% discount to our fair value estimate. Schlumberger has the highest international share of revenue among peers, making it best positioned to take advantage of the rebound in capital expenditures. Also, we think the company is poised to gain market share via its efficiency-boosting integrated project initiatives.
The market wasn’t encouraged by Schlumberger’s and peers’ reports of tepid international services pricing in the first quarter, but we think activity increases plus disciplined behavior by the major players (which continue to compete in relatively oligopolistic markets) will lead to improving pricing in the next few years.
Halliburton (HAL) also looks attractively priced. Our long-held bearish thesis has more than played out, and sentiment has become so negative that the stock now looks cheap to us. Halliburton should benefit from the international capital expenditure recovery just like Schlumberger. Also, while we have long cautioned about the competitive headwinds for Halliburton in U.S. shale, we don’t think the company’s U.S. shale profitability will disappear overnight--nor do we think all of its U.S. shale economic profits will erode over the long run. We think the market has become overly discouraged by the short-term slowdown in U.S. shale activity caused by temporary pipeline bottlenecks.
Likewise, TechnipFMC (FTI) looks cheap. Its subsea end market will benefit from a sharp rebound in offshore capital expenditures in coming years, and we think the company will also gain market share due to its leading capabilities in integrated projects.
Finally, National Oilwell Varco (NOV) looks like a bargain. NOV has underperformed the sector along with the offshore drillers for the past two months. In its rig technologies segment, we don’t think the market-implied outlook can get much worse. We assume virtually no rig newbuilds in our forecasts, with our projected segment revenue instead coming from drillers’ maintenance capital expenditures, which should increase steadily in the coming years. NOV’s non-rig segments will benefit from the ongoing recovery in overall global capital expenditures as they compete in many of the same product lines as Schlumberger and Halliburton.
Dave Meats does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.