Energy Stocks: Gusher or Dry Hole?David Bogoslaw
Investors who are still convinced oil prices are headed higher even if the economic recovery turns out to be much slower than initially expected must have been taken by surprise last week, as oil prices fell 10%, dragging energy stock prices down with them.
Energy investors got another kick in the pants on July 9, when Chevron (CVX) announced that its second-quarter earnings would be hurt by lower U.S. refining margins and currency effects. The week was capped by yet another setback for the energy crowd: On July 10, Nymex crude oil for August delivery finished 55¢ lower, at $59.86 a barrel, 18% lower than its recent peak above $73 a barrel on June 30.
Much of last week's pessimism about energy stemmed from the announcement that the Commodity Futures Trading Commission plans to push for regulations that would sharply limit the extent to which hedge funds and other financial market speculators can invest in oil futures. But appreciation in the value of the U.S. dollar against key foreign currencies like the euro also curbed appetite for commodities, whose popularity has largely been based on the protection they offer from inflation.
Speculators in the Mix
There's still a lot of disagreement among analysts and fund managers as to what level oil prices should be at, based on current and projected future supply-and-demand fundamentals. Fadel Gheit, an analyst at Oppenheimer & Co. (OPY), thinks oil prices should be between $45 and $55, with $55 being "the speed limit" if demand rebounds when the global economy recovers, given how much excess supply there is around the world. He sees the clear hand of speculators in the price of oil jumping 120% between December and the end of June even as demand forecasts were declining.
On the opposite side, Andrew Lees, lead manager of the AIM Energy Fund (IENAX), believes prices need to be significantly higher to give producers incentive to start new projects when they don't know how high the future carbon capture costs that may result from pending legislation will be. "If climate legislation truly demands we start sequestering all CO2 [emissions], there's no technology to do that right now," he says. "So what price do you have to put on crude oil to justify future investment when you have no idea what the cost of future carbon capture is going to be?"
As long as that cost is unknown, it's impossible for producers to project what the marginal cost of production will be in the future, and therefore how high an oil price is needed to guarantee a certain rate of return, adds Lees. He believes that's been one factor contributing to the rapid runup in oil prices in recent weeks.
Surge Seen as Premature
Daniel Rice, portfolio manager of the BlackRock Global Resources Fund (SSGRX), more than 64% of whose allocation is in energy stocks, says the surge in oil prices above $70 was premature given the amount of excess inventory worldwide. He thinks the runup was more of a trade by investors seeking to hedge against a weakening dollar than something based on supply-and-demand factors. But that doesn't mean he's not optimistic about the longer-term prospects for oil prices based on the magnitude of the growth he expects in global gross domestic product a year from now.
The stocks of integrated oil producers and exploration and production companies are now discounting a global oil price between $50 and $55 a barrel, but that's justified only if you believe global gross domestic product will contract by 2% a year on a sustained basis, he says. Even zero growth in the global economy warrants an oil price closer to $70 a barrel, he says.
"[Oil stocks are] saying we're in a longer term -2% GDP world. If you think differently, you'll have a lot of value [in oil stocks]," he says. He thinks oil-stock prices are attractive because investors are underestimating the potential for a quicker recovery. "I think the world will be at +2% GDP growth by the middle of 2010, powered by China," whose economy he expects to grow at 9% a year over the long term.
Hess a Favorite
Since 2% global economic growth should justify oil prices between $80 and $90, oil stocks have potential to double or triple over the next 12 months or so, he says. Every $5-per-barrel gain in the perceived price of oil translates to a 20% rise in stock prices, he adds.
Lees of the AIM Fund thinks it may take until 2011 until the global economy is able to return to 3% growth, but he says a "bigger concern is we don't have the crude oil to produce more than 90 million barrels a day" to support that level of growth.Hess Corp. (HES) is a more aggressive way to play the major oil producers if you're confident about higher oil prices over the long term, according to a July 8 research note from Raymond James & Co. (RJ). Hess is one of just five U.S. majors that Raymond James covers that has met both production and reserve growth forecasts in each of the last three years, the note said.
Betting on Occidental Petroleum
"Within the context of our recently increased (to $80 per barrel) oil price forecast, we would use the recent pullback as an opportunity to accumulate Hess shares," analyst Pavel Molchanov said in the note. Raymond James reconfirmed its outperform rating on Hess and said its $64 price target was based on a 17 times multiple of its new 2010 earnigs estimate. That's higher than the company's average multiple of 11 times earnings over the past 10 years but less than the proved net asset valuation of $88.69 a share, the note said.
Occidental Petroleum (OXY) is one of Lees' preferred names based on its asset base, quality management, and outlook. It traditionally generates among the best rates of return and has been a leader in driving costs back down. He thinks the company can grow production per share by 5% to 10% for a long time with its existing and prospective projects — from the Middle East to Monterey, Calif. — lined up for the next one to two years.
The prospects for the stocks of natural gas producers aren't nearly as promising in the near term, given the consensus that gas prices won't rebound any time soon. Many producers that focus on unconventional gas resources such as shale and tight sandstone aren't currently discounting much upside in their unconventional assets, says Joseph Magner, an analyst at Tristone Capital USA in Denver.
Debt-Laden Balance Sheets
"What it comes down to now is prices and costs, and which of these producers will effectively be able to adjust their cost structures so they will be able to effectively and economically develop that unconventional resource," he says. Right now there's little willingness among investors to discount those resources given the restrained expectations for natural gas prices, he adds.
Natural gas stocks are trading at parity with their current proved reserves, says Jonathan Wolff, an E&P analyst at Credit Suisse (CS). Although some companies have unconventional reserves they aren't yet getting credit for that could, once they're recognized as probable reserves, boost stock valuations, most of those producers aren't generating the cash flow needed to finance development of those properties because of currently low gas prices. Producers would be able to materially increase their booked reserves over time if the price of natural gas was to rise to $7 per thousand cubic feet, but at prices half that level, companies need to use debt and equity to fund development costs, he says.
Balance sheets for the natural gas industry, laden with debt, don't help make the case for investing in exploration and production companies right now, either. In the first half of 2009, these companies issued more than $17 billion in debt and equity in order to pay down outstanding debt on revolving credit lines at banks, which are at greater risk of being reduced the longer gas prices stay depressed, he says.
Another Year of Soft Prices
And earnings will be further challenged by likely production cuts in 2010. "The average natural gas producer, based on [prices] for next year, will have 13% less cash flow than their budgets are this year," says Wolff. "That means they have to spend 13% less next year or they have to finance it with equity or debt, unless the [gas] price bounces."
With gas supply up by about 5% and demand down 5% from last year, the market won't tighten much before mid- to late 2010, so he says he expects fairly soft prices for another 12 months or so.
Still, a few producers stand out based on their operational edge and dominance in certain markets such as the Fayetteville, Ark., shale resources. Lees at Invesco AIM, likes Southwestern Energy (SWN), which he sees as cheap on a net asset value basis despite seeming expensive based on price-to-earnings. "They're growing into their p-e," he says. Besides having 50% production growth so far this year, the company is lowering its cost structure based not only on falling oil service costs but by using what it's learned from prior development to save money through smarter drilling.
Unsettling Times Ahead
If a strict carbon capture regime emerges, the price premium that oil has enjoyed could disappear and natural gas producers would benefit. Wolff at Credit Suisse believes a carbon policy would be positive for natural gas in the long run since the fuel generates roughly one-half of the CO2 emissions of coal, which would help increase market share for natural gas as a fuel source for power plants. "The industry is doing a better job [than in the past] of promoting the fuel as being available and clean, and policymakers are getting the message," he says. "It's just a matter of time before it becomes obvious we should facilitate higher demand for gas. It's available and it is domestic."
That certainty fits the bill for people calling for reducing U.S. dependence on foreign oil in the future. But for now, gas producers, along with their petroleum-pumping peers and energy investors, will be sweating out some unsettling times.