Get the Latest Investment Ideas Delivered Straight to Your Inbox. Subscribe

Oil and Gas Stock Outlook

Share on Stocktwits

Source:

"Crude oil's near-term fundamentals remain mixed, to say the least. The long-term outlook for oil, however, remains favorable given the commodity's constrained supply picture and continued strength in the major emerging economies."

Outlook for Crude Oil

Signs of progress in resolving Europe's long-running sovereign debt crisis and a tightening global supply picture in view of the geopolitical fallout over Iran's alleged nuclear ambitions have been keeping oil prices at elevated levels. Partly offsetting this favorable view has been high U.S. crude stocks and worries about China's growth outlook.

As such, crude oil's near-term fundamentals remain mixed, to say the least. The long-term outlook for oil, however, remains favorable given the commodity's constrained supply picture. In particular, while the Western economies exhibit sluggish growth prospects, global oil consumption is expected to get a boost from continued strength in the major emerging powers like India, China and Brazil that continue to grow at a healthy rate.

According to the Energy Information Administration (EIA), which provides official energy statistics from the U.S. government, world crude consumption grew by more than 1 million barrels per day (MMb/d) in 2011 to a record-high level of 88.1 MMb/d. In 2010, oil demand increased by over 2 MMb/d to 87.1 MMb/d, which more than made up for the losses of the previous two years and surpassed the 2007 level of 86.3 MMb/d (reached prior to the economic downturn). One might note that global demand for 2009 was below the 2008 level, which itself was below the 2007 level—the first time since the early 1980s of two back-to-back negative growth years.

The agency, in its most recent "Short-Term Energy Outlook," said that it expects global oil demand growth of 1.3 MMb/d in 2012 and 1.5 MMb/d in 2013. EIA's latest forecasts assumes that demand will be essentially flat in North America and Europe but this will be more than made up by impressive consumption surge coming from China, the Middle East and Brazil.

Separately, the Organization of the Petroleum Exporting Countries (OPEC)—which supplies around 40% of the world's crude—predicts that global oil demand would increase by 1.1 MMb/d annually, reaching 88.9 MMb/d in 2012 from last year’s 87.8 MMb/d.

Lastly, the third major energy consultative body, the Paris-based International Energy Agency (IEA), the energy-monitoring body of 28 industrialized countries, said that it expects world oil consumption to grow by 1.1 MMb/d in 2012 to 90 MMb/d.

In our view, crude oil prices in 2012 are likely to witness significant upside—rather than downside—given the considerable supply tightness in the market. While domestic demand is relatively soft and the global economy still showing signs of weakness, the fact that demand is outpacing supply appears to be palpably evident.

As long as growth from the developing nations continues and the global output is unable to keep up with that, we are likely to experience a surge in the price of a barrel of oil. With a seven-billion-strong world population and all the easy oil being already discovered and expended, we assume that crude will trade in the $95-105/bbl range in the near future.

Outlook for Natural Gas

Over the last few years, a quiet revolution has been reshaping the energy business in the U.S. Known as 'shale gas'—natural gas trapped within dense sedimentary rock formations or shale formations—it is being seen as a game-changer, set to usher in an era of energy independence for the country. The success of this unconventional fuel source has transformed domestic energy supply, with a potentially inexpensive and abundant new source of fuel for the world’s largest energy consumer.

With the advent of hydraulic fracturing (or fracking)—a method used to extract natural gas by blasting underground rock formations with a mixture of water, sand and chemicals—shale gas production is now booming in the U.S. Coupled with sophisticated horizontal drilling equipment that can drill and extract gas from shale formations, the new technology is being hailed as a breakthrough in U.S. energy supplies, playing a key role in boosting domestic natural gas reserves.

As a result, once faced with a looming deficit, natural gas is now available in abundance. In fact, gas stocks—currently 25.4% above the five-year average and 24.6% higher than the same period last year—are at their highest level for this time of the year, reflecting low demand amid robust onshore output.

Looking ahead, EIA expects average total production to rise by 2.2% in 2012 (to an all-time high 67.3 billion cubic feet per day [Bcf/d], easily eclipsing 2011's record high estimate of 65.9 Bcf/d), while total natural gas consumption is anticipated to grow by just 2% next year. We believe these supply/demand dynamics—the projected lower consumption growth compared to production—will weigh on natural gas prices, translating into limited upside for natural gas-weighted companies and related support plays.

In the absence of major production cuts or a stronger economy to boost industrial demand, which is responsible for almost a third of the gas consumption, we do not expect much upside in gas prices in the near term. In other words, there appears no reason to believe that the supply overhang will subside and natural gas will be out of the dumpster in 2012.

In the past, winter weather has played a factor in boosting prices with demand for domestic natural gas exceeding available supply. But with no dearth of new supply, even this association is becoming more and more obsolete.

Opportunities

In this current turbulent market environment, we advocate the relatively low-risk energy conglomerate business structures of the large-cap integrateds, with their fortresslike balance sheets, ample free cash flows even in a low oil price environment and growing dividends. Our preferred name in this group remains Chevron Corp. (CVX).

Its current oil and gas development project pipeline is among the best in the industry, boasting large, multiyear projects. Additionally, Chevron possesses one of the healthiest balance sheets among peers, which helps it to capitalize on investment opportunities with the option to make strategic acquisitions.

The current oil price environment should also benefit producers, particularly those international players having attractive growth opportunities in their home markets. One such standout name is PetroChina Company Limited (PTR), which remains well-placed to benefit from the country’s growing appetite for energy and the turnaround in commodity prices. PetroChina—one of two Chinese integrated oil companies—is poised to capitalize from the country’s impressive economic growth that has significantly increased its demand for oil, natural gas and chemicals.

Within the oilfield services group, we like Halliburton Company (HAL). We are a fan of the Houston, Texas-based player's leading position in the global oilfield services market, its broad and technologically-complex product/service offerings, and its robust financial profile. The company has been benefiting from increased activity in the unconventional shale plays in North America, which has more than made up for the drop in deepwater Gulf of Mexico activity and disruptions in North Africa.

Denbury Resources Inc. (DNR), a leading CO2 'Enhanced Oil Recovery' (EOR)-focused company targeting a large attractive market, is also a top pick. With its unique profile, compelling economics and an unmatched infrastructure, Denbury is nicely positioned to deliver long-term sustainable growth. Additional positives for Denbury include a strong financial position, low-risk investments and an active divestment policy.

Further, we remain optimistic on the near-term prospects of South African petrochemicals group Sasol Ltd. (SSL). We like Sasol for its diverse portfolio of assets that produce a wide array of chemical and liquid fuels. The company specializes in gas-to-liquids (GTL) and coal-to-liquids (CTL) technologies, which convert natural gas and coal to diesel and other liquid fuels.

Recently, these technologies have been attracting attention because they provide an alternative to traditional oil. Additionally, Sasol’s deleveraged balance sheet and strong cash position keeps the group well-equipped to weather the global economic storm and fund its growth program in tough credit markets.

Canada's biggest energy firm and the largest oil sands outfit, Suncor Energy Inc. (SU), is also worth a look. We like the company's impressive portfolio of growth opportunities, unique asset base and high return potential in the long run. Suncor has significant oil sands and conventional production platform, huge long-lived oil-sands reserves and a robust downstream portfolio.

The company's asset base includes substantial conventional reserves and production offshore in eastern Canada and in the North Sea, which generate strong margins and should provide free cash flow to fund future oil sands expansion.

Finally, despite the depressing natural gas fundamentals and the understandable reluctance on the investors’ part to dip their feet into these stocks, we would advocate to opt for EOG Resources Inc. (EOG), a former natural gas exploration and production (E&P) company that has made significant headway into the more profitable oil space with the introduction of the commercial viability of shale oil.

Weaknesses

We are bearish on Italian energy company Eni SpA (E). The integrated player—with a large presence in Libya—has seen its total production drop by 13% during the most recent quarter, primarily due to operational disturbances at several fields in the North African nation.

Additionally, Eni's upstream portfolio carries greater political risk than its peers, since it has the highest exposure to the OPEC countries. Given these concerns, we expect Eni to perform below its peers and industry levels in the coming months. As such, we see little reason for investors to own the stock.

Calgary, Alberta-based oil and gas outfit Talisman Energy Inc. (TLM) is another company we would like to avoid for the time being. With core operations in the North Sea, Talisman has been adversely affected by last year’s tax hike in the region, along with maintenance/production issues that have created investor concerns about the company’s sustainable operational efficiency and execution abilities.

We are also skeptical on independent energy exploration firm Cabot Oil and Gas Corp. (COG). Cabot was the best performing S&P stock for 2011, gaining almost 100% during the period. The natural gas producer defied weak commodity prices to set a scorching pace in a year that saw the overall index decline 0.6%.

Most of the gain was driven by its exposure to the high-return Marcellus and Eagle Ford Shale plays, as well as its above-average production growth. But given natural gas's weak fundamentals and Cabot's high exposure to the commodity, we do not believe that the stock will be able to sustain the momentum in the near future. Cabot's steep valuation and miniscule payout also keep us worried.

Further, we remain cautious about natural gas-focused energy firm Questar Corporation (STR). The expected bearish natural gas fundamentals over the next few quarters and excessive domestic gas supplies is likely to restrict near-term growth prospects at Questar Pipeline. We also believe that upside potential will remain limited until the company has fully reaped the benefits of the spin-off of its unregulated E&P business.

We recommend avoiding names like Sunoco Inc. (SUN), whose East Coast-based downstream units have been performing poorly during the last few years, hampered by higher crude prices, while their mid-continent competitors continue to benefit from the lower oil prices caused by the crude glut in Cushing. Though the company is planning to exit its refining business on or before July 2012, we believe the realignment of Sunoco will take some time to bear results.

Lastly, we expect shares of offshore driller Noble Corp. (NE) to be under pressure in the near future. In particular, the company's old and less efficient fleet in a cutthroat environment could prove detrimental.

On the arrival of newbuild rigs into the market, many of the company's older rigs, floaters as well as scores of jack-ups, will face the threat of departure, resulting in a risk of earnings dilution from the retirement of older specification rigs. Additionally, with core operations in the Gulf of Mexico, Noble has been adversely affected by continued delays in normalized activity in the region following the oil spill, along with the introduction of new and more stringent regulations.

Zacks Equity Research

Zacks.com


Want to read more about Oil & Gas - Exploration & Production investment ideas?
Get Our Streetwise Reports Newsletter Free and be the first to know!

A valid email address is required to subscribe