As of this writing, the S&P 500 is only about 5% below its all-time high, but that figure understates the extent of recent volatility. Energy stocks are down by nearly 25% over the past three months, and there are now 37 energy companies carrying Morningstar’s five-star rating, meaning they are significantly undervalued.
That’s compared with just 10 five-star stocks across Morningstar’s entire coverage universe when we published our last quarterly outlook. Our broader coverage universe now includes 64 five-stars, with the median stock trading 1% below fair value, by our estimation.
Our contrarian take on energy has a simple explanation: Investors are terrified of the 45% collapse in crude oil prices since June, but our analysts think this is a temporary setback. While we’ve lowered our near-term oil price expectations in line with the market, our long-run oil price forecast remains $100/barrel for Brent.
And the “long run”—all the years beyond the next three—is the primary determinant of our fair value estimates.
To be sure, the speed and extent of the recent plunge in oil prices took us by surprise after more than three years of relatively stable prices in the $100/barrel range. It’s all about Economics 101: supply and demand. North America’s energy boom has increased supply, augmented by surprisingly strong production out of the Middle East and North Africa despite political turmoil in that region. At the same time, the demand outlook has weakened, with many economies around the world slowing such as China or in borderline recessions such as Japan, Brazil, and much of Europe.
Morningstar’s long-run oil price assumptions are based on the “marginal cost of production” —we believe a Brent price of $100/barrel is necessary to stimulate investment in the highest-cost resources such as ultra-deep-water and oil sands mining. However, investors should keep in mind that marginal cost is a moving target. First, growth in lower-cost sources of supply—especially if combined with slowing demand—can push high-cost resources off the supply curve altogether. If we can meet our oil needs without the highest-cost resources, then they lose their relevance to setting oil prices.
Second, oilfield-services pricing is a major determinant of marginal costs. As oil and gas companies cut back on drilling, there may be an excess supply of rigs, equipment, labour, and so on, resulting in lower services pricing and lower marginal costs. At the very least, investors should understand that our $100/barrel forecast involves a high degree of uncertainty, making a margin of safety indispensable for new purchases.
On the plus side, such margins of safety are now widely available in energy, even though we’ve been ratcheting down our valuations to incorporate lower near-term oil prices. The median energy stock in our coverage universe is trading 27% below our fair value estimate, making energy the cheapest sector on that measure by far. There are two key factors that should support oil prices over the longer run: Natural decline curves, which reduce global oil supply by 4%–5% per year absent new investment, and the fact that incremental oil and gas resources are in relatively remote, difficult-to-access locations.
Risk and Reward Go Hand in Hand
A theme from the energy sector pervades the rest of the market as well: Undervalued stocks generally come with elevated risk, especially from economic sensitivity and currency exposure. After energy, the next most undervalued sector we cover is basic materials, where the median stock is trading 11% below our fair value estimate.
The basic materials sector has been down over the past three months because of concerns about slowing economic growth in China. It’s hard to overstate the importance of China to global commodities demand. For example, China accounts for about half of global steel demand and two thirds of the seaborne iron ore market. We think China’s steel consumption has peaked and is set for a steady decline over the next several years as the Chinese economy rebalances toward consumption instead of investment spending. Iron ore prices fell by half thus far in 2014, and we think other commodities such as copper won’t be far behind.
