Crude oil prices are down sharply in recent weeks, and with them, energy stocks. We understand the crude market’s reaction to worsening short-term fundamentals, but feel that equity markets have over-reacted, misinterpreting how lower prices will affect cash flows for oil and gas firms.
What’s driving crude prices lower is slowing demand in the face of growing U.S. tight oil production and the return of 500 mb/d of Libyan crude oil to global markets since July. Markets have known and discounted tight oil production from the U.S., which will add roughly a million barrels a day of crude oil production this year and next, but the resumption of Libyan exports has hit the market just as the International Energy Agency has been lowering oil demand forecasts for 2014 and 2015. The result is a fear of oversupply, leading to lower prices.
Surging crude oil supply, weakening demand, and the strengthening U.S. dollar resulted in a 13% drop in global crude oil prices in the past month and a 24% drop from their 2014 peak of $107/bbl, a reflection of near-term fundamentals, not longer-term supply and demand trends, in our view.
Our estimate of the marginal cost for crude oil remains $90 per barrel for West Texas Intermediate (WTI) and $100 per barrel for Brent, and we see little evidence today that the cost of incremental production has changed significantly.
Our sense of short versus long term may not match up well with consensus views. In the context of oil markets, we consider short term to be the next 18-24 months, and in our view, today’s supply-demand imbalance is a short-term issue.
At present, it appears that markets will be oversupplied with crude and oil prices will take a hit as a result. Lower prices then reduce returns for new investment and make marginal projects non-commercial. However, it takes the physical market a couple of quarters to react, but eventually supply will tighten as marginal wells don’t get drilled and marginal production doesn’t make it to market.
The 20%-30% fall in share prices of oil and gas companies is a disproportionate response to oil price fundamentals and out of line with valuation impacts in our view. In contrast, we test $75 per barrel for WTI and $80 per barrel for Brent through 2016 and find that the fair value estimates of most energy companies would drop 5%-8% compared with their valuations at current strip prices.
Which Stocks Look Attractive?
The fall has created some compelling opportunities in some cases by sending many shares well below our fair value estimates. Investors who are looking to take advantage of the sell-off but remain wary about the near-term outlook for oil prices might be better off adding these integrated names. While holding leverage to any recovery oil prices, integrated companies also offer more protection in a downside scenario given their much stronger balance sheets and downstream assets.
Downstream operations are less correlated with oil prices and can offer an earnings and cash flow buffer when oil prices and upstream earnings are volatile. Combined with the stronger balance sheets, integrated companies are in a better position to continue paying dividends and repurchasing shares during an extended downturn. While they likely wouldn’t need to, integrated companies may trim investment plans, but given the group’s longer investment cycle, near-term growth would not be at risk.
Our top picks also remain the same, BP (BP.) and Exxon (XOM), as they continue to trade at steep discounts to our fair value estimates and are still better positioned to deliver peer-leading free cash flow growth. Other names we’d highlight are BG Group, which is trading near 5-star territory and has several near-term catalysts.
Interestingly, Petrobras actually benefits from lower oil prices, especially in the near term as reduced downstream losses would outweigh lost upstream income. As a result, our fair value actually increases with lower oil prices. Though a bit riskier given their greater oil price leverage, several Canadian producers are attractive as well, most notably MEG Energy (MEG), which has sold off the most of the group in the last month. MEG does not have refining assets, making it a bit riskier. However, Cenovus (CVE) has underperformed all year, but the recent sell-off has made it compelling.
This article is part of a longer report into oil and gas stocks. For the full report go to Morningstar Select
