Oil & Gas Stock Outlook

Crude Oil

Mounting worries about Europe's debt crisis, a persistently weak U.S. jobs market and less-than-encouraging guidance from the Federal Reserve have been weighing on investor sentiment, weakening oil prices to around $85 a barrel.

Apprehensions about high U.S. crude stocks, the release of emergency oil supplies from government-held strategic reserves into the world market, and uncertainty over oil supply disruptions in the Middle East have added to the negative sentiment.

These issues have stoked fears about the demand outlook for oil that has seen the commodity's price plummet to 12-month lows earlier in the month. Incidentally, crude prices zoomed past the $110 per barrel level during the first half of the year.

As per the latest release by the Energy Information Administration (EIA), which provides official energy statistics from the U.S. Government, crude supplies are still in the upper limit of the average for this time of the year. This has led to domestic demand concerns against a backdrop of continued weak job growth.

But while the Western economies exhibit sluggish growth prospects, global oil consumption is expected to get a boost from the sustained strength in the major emerging powers like India and China that continue to grow at a healthy rate.

As such, crude oil's near-term fundamentals remain patchy, to say the least. The long-term outlook for oil, however, remains favorable given the commodity's constrained supply picture.

According to the EIA, world crude consumption grew by more than 2 million barrels per day (M bpd) in 2010 to a record-high level of 87.1 Mbpd, which more than made up for the losses of the previous 2 years and surpassed the 2007 level of 86.3 Mbpd (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 1980's 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 Mbpd in 2011 and 1.4 Mbpd in 2012. EIA's latest demand growth forecast for 2011 is 50,000 barrels per day lower than in the earlier version, as the agency sees declining consumption in developed countries. But for 2012, EIA has raised its global oil demand forecast by the same amount, stressing on robustness in China and other emerging economies.

Recently, the Organization of the Petroleum Exporting Countries (OPEC)—which supplies around 40% of the world's crude—trimmed its 2011 and 2012 world oil demand growth outlooks, citing the unsteady global market and in particular the worsening economic outlook in the more developed countries. OPEC predicts that global oil demand would increase by 880,000 barrels per day annually, reaching 87.81 Mbpd in 2011 from last year's 86.93 Mbpd.

OPEC's current growth estimate for 2011 is lower by 180,000 barrels a day from its last report, issued in September 2011. In 2012, OPEC expects global oil demand to grow at a slightly higher 1.19 Mbpd. This reflects a downward revision of 80,000 barrels per day from the previous month's report.

The third major energy consultative body, the Paris-based International Energy Agency (IEA), the energy-monitoring body of 28 industrialized countries, also forecasted weaker-than-previously-anticipated global oil demand growth in 2011 and 2012. In its latest 'Oil Market Report,' IEA said it expects world oil demand to grow by 1 Mbpd in 2011, reflecting a downward revision of 50,000 barrels a day over the previous assessment.

For 2012, the agency has curbed its estimate for world oil demand growth by 210,000 barrels per day and now sees consumption to grow by 1.3 Mbpd. IEA has attributed the cuts in its oil demand growth outlook to downward adjustment to global GDP growth assumptions.

We expect crude oil to trade in the $85-$95 per barrel range in the near future, reflecting upward pressure due to supply uncertainty from the ongoing unrest in oil-producing regions and downward pressure because of lower economic growth expectations.

Natural Gas

A supply glut pressured natural gas futures for much of 2010, as production from dense rock formations (shale)—through novel techniques of horizontal drilling and hydraulic fracturing—remain robust, thereby overwhelming demand.

As per the U.S. Energy Department, domestic gas output increased significantly in 2010, by an estimated 2.4 billion cubic feet per day, or 4.1%, as production declines in Alaska and the Gulf of Mexico were offset by a healthy increase in lower-48 onshore volumes. Storage amounts hit a record high of 3.840 trillion cubic feet in November, while gas prices during the year fell 21%.

However, stocks of the commodity slid approximately 2.261 Tcf during the five-month period (November 5, 2010 to April 1, 2011) on the back of a colder-than-normal end to this past winter, production freeze-offs in January/February, and the steadily declining rig count.

These factors cut into the U.S. supply overhang, thereby creating a deficit in natural gas inventories after erasing the hefty surplus over last year's inventory level and the five-year average level.

However, natural gas demand is currently going through a lean period with the end of the peak cooling loads for summer and ahead of the winter heating season, coupled with tepid industrial demand in a weak economy.

Looking ahead, EIA expects average total production to rise by 6.7% in 2011 and by 2.1% in 2012, while total natural gas consumption is anticipated to grow by 1.9% this year and by a marginal 0.7% during the next year.

We believe these supply/demand dynamics—the projected lower production growth and almost flat consumption—will lead to the strengthening of natural gas prices in 2012.

But until then the weak fundamentals are going to continue to weigh on natural gas prices, translating into limited upside for natural gas-weighted companies and related support plays.

Weaknesses

The current turbulent market environment—characterized by the decline in short-term demand assumptions on the back of recession fears in the U.S. and EU and high uncertainty—have taken its toll on the energy conglomerate business structures of the large-cap integrateds. The dip in oil prices to around $80 per barrel is likely to further limit their ability to generate positive earnings surprises.

Companies' high natural gas exposure raises their sensitivity to gas price fluctuations, compared to the more-diversified independent peers with a balanced oil/gas production profile. Continued low natural gas prices have created a difficult operating environment for the firms.

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