Domestic Oil Production Is Bullish for Americans: Evan
Source: George Mack of
For Morgan Stanley Analyst Evan Calio, a challenge is really
an opportunity, at least when it comes to finding discounted
equities in the oil and gas space. In this exclusive interview
The Energy Report
, he explains why the distribution bottleneck that is causing a
historically wide price differential between WTI and Brent is
actually an opportunity for refiners and Americans
The Energy Report:
Oil and gas controversies are all over the news these days. Evan,
what is your take on the space?
Energy is a challenging space currently. The biggest story right
now is the widening West Texas Intermediate (
) discount to water-borne, global crudes like Brent, largely as a
result of unconventional oil production growth in the U.S. Our
five-year forecast for U.S. oil liquids production growth is 2
million barrels per day (MMb/d). You could add some of the
Canadian barrels that ultimately should travel into the U.S.
refining system of almost 700 thousand barrels per day (Mb/d).
That is a pretty material amount of production growth on a
relative basis and could result in increasing U.S. oil
independence. Not since the late 1960s have we seen that type of
relative oil production growth.
Production growth has been a big boon to the midstream
infrastructure space that constructs the pipeline architecture
and then moves the crude to new areas. It has also been a
significant tailwind for the U.S. refining sector, which has been
the best performing energy subsegment for the last three years
running. Seasonal strength in the refining trade has been
exacerbated, which led to some recent negative price movement.
Overall, the U.S. production growth and the latency of the
midstream architecture and the relatively low cost of natural gas
in America are all things that have turned the U.S. from its
historic role as a net refined products importer in 2008 to a
significant net exporter today. We are taking market share at
much better profitability than some of the traditional global
The crude production story is also impacting our names on the
upstream side. Essentially, it's providing them with incremental
growth profiles versus what they've had historically. I think
some of that is offset by lower gas production driven by lower
prices. It has also led to an increase in overall capital
expenditures coming into this year. A combination of fear of
current oil prices, possibly lower natural gas prices and higher
costs have acted as a headwind to that sector so far this year.
That is driving the outperformance in the refining sector and
will help the upstream oily names at some point this year.
What caused the price differential between Brent and WTI?
Greater production in North America built up before
infrastructure was available to move it to the water and on to
places with big refining sectors. The midcontinent region of the
U.S. is primarily a net importer of refined product so it is set
to global pricing while the crude feedstock costs are local and
discounted. It has been a big earnings boon to the U.S.
midcontinent refining system. The U.S. independent refiners have
some exposure to this midcontinent phenomenon so they can access
those discounted crudes. That is really helping them.
Why hasn't the spread between Brent and WTI narrowed as
infrastructure kicked in?
It is narrowing a bit. However, there have still been too few
direct connections between Cushing, Oklahoma, and the U.S. Gulf
Coast. As we move into June, the 150 Mb/d Seaway connection will
go into service. It is in the process of being reversed; it used
to go from south to north and now it's going to go from north to
south, from Cushing to the Gulf Coast. That will be the first
direct pipeline access to the Gulf but it is still not enough to
handle all the excess production.
The reason that the spread has remained wide is because there
is no easy way to arbitrage it. If there was a limitless pipeline
that connected Cushing to the Gulf Coast, the price differential
between Cushing and the Gulf Coast would be equal to the cost to
ship on that pipeline. The Seaway reversal could result in a $4
downside to the spread short term, but in the back half of the
year, it will begin to widen out to around current levels. That
is our forecast for the WTI-Brent spread in 2012. In 2013, Seaway
could more than double capacity and eventually move 800 Mb/d,
which would compress the price closer to the cost of the marginal
barrel out of a particular basin. Tariffs on new lines could keep
prices above historic differentials for the long term.
Originally, the plan was for Keystone XL to take 500 Mb/d of
crude from Hardisty in Canada all the way to the U.S. Gulf Coast
where higher complexity refiners can process heavier crudes. Now
with that pipeline blocked, a path is essentially being cobbled
together in reverse. This will result in a lot of other
differentials around the country until freer access is built to
the Gulf Coast. This year we could see similar problems around
lack of takeaway capacity in the Permian Basin. The Permian is
now trading $8 under WTI; it used to trade less than $1 under
WTI. People who can access that crude have an advantage. The
Bakken is trading at a wider differential to WTI, and WCS
(Western Canadian Select) is trading at the widest differential.
Transporting crude by train can cost $15/barrel (bbl).
There is a lot of optimism around the Utica in Ohio. Its
potential shale formation will get more data from well results
over the next few quarters fromChesapeake Midstream Partners L.P.
(CHKM:NYSE) andAnadarko Petroleum Corp. (APC:NYSE) . The problem
is that this will be another area that doesn't currently have
significant transportation architecture. That could result in
incremental midstream pipe-building, gathering and processing,
which is pretty bullish for us.
When you say bullish for us, you're talking about your
I'm talking about you and me, the American people. In the U.S.
right now, we pay a significant overall natural gas cost
differential. Natural gas is around $2/thousand cubic feet
equivalent (Mcfe). Liquefied natural gas (
) is $14/Mcfe on a contract basis and $17/Mcfe on the spot
market. It's $10/Mcfe in Europe-that is a significantly cheaper
hydrocarbon molecule. Eliminating 2 MMb/d of crude imports will
impact the U.S. balance of trade and provide a lot of jobs
because these molecules are a little bit more labor intensive to
produce. An American Petroleum Institute (
) study released in September showed that if the U.S. changes the
way it regulates hydrofracks, it could create 670,000 jobs and
increase domestic tax and royalty revenues. It could also benefit
the service industry by expanding demand for rigs, trucks and
these kinds of things. So when I say it's bullish, I say it's
bullish for America, bullish for you, bullish for me, bullish for
I realize that volumes are the drivers for the midstream and the
downstream, but your commodity specialist is forecasting Brent at
$105/bbl. That sounds bearish to me. How do you strategize around
The commodity curves are very backward dated, meaning that the
futures prices are significantly below the front-year pricing.
Some of this supply-driven tightness relates to geopolitical
problems, which remove supply from the market and is
fundamentally different than demand-driven strength. It happens
almost every year. The Arab Spring drove Brent crude to $125/bbl
last year just as the Iranian crisis did this year.
So what do you do? When everyone believes the oil price is
going to drop and the stock prices reflect a drop that exceeds
the drop in the commodity, then you are reaching valuations at
which stocks become interesting. I think we are getting to those
With most of the market, it's been better to be defensive and
be in lower beta, better balance sheet equities in terms of the
integrateds with some dividend support.Chevron Corporation
(CVX:NYSE) ,Exxon Mobil Corp. (XOM:NYSE) andConocoPhillips
(COP:NYSE) are being relatively lower weighted for everything
else within energy. Part of it is driven by the fact that the
market isn't paying for overall supply-driven oil, especially
once it got to a $125/bbl level, a place that would run risk to
the tape. Plus, a warm winter and lots of associated production
have resulted in significant underperformance.
Evan, can we talk about some of the stocks that you're talking to
your clientele about?
One stock that's been a big call for us isCobalt Energy Group
(CIE:NYSE) , a 100% exploration stock. It has almost tripled from
when we recommended it in late December after initial data was
released on a discovery in Angola. We were the most vocal on the
stock into what I think was a transformative discovery in the
Angolan pre-salt play.
Are you still very bullish on it?
Yes. We're overweight. The next catalyst will be an appraisal
well result in the May-June timeframe. It is unique because it
will be drill-bit driven rather than commodity- and
macroeconomic-dependent. We think it can clearly double from
here. I see a lot of value support in the continued drilling and
proving up of the resource in Angola in delineating its prospects
in the Lower Tertiary, which is the Gulf of Mexico, and the Lower
Tertiary pre-salt play. If we get our first well in the back half
of the year in North Platte at $6 to the net asset value (
) of the stock, it will derisk six other prospects as well as a
bigger inventory on that play concept. North of Angola is a very
interesting block where Cobalt is participating withTotal S.A.
(TOT:NYSE) on a well in Gabon. It should start drilling this
year, but you'll get results into 2013 that are three or four
times the value of Angola in terms of a per barrel basis. We're
talking about a multibillion-barrel prospect. So it's a mid-cap
company that is entirely unique in our view.
It's interesting. Over the last 12 weeks, it's up 60%. And after
all of this activity, up 227% over the past six months; it didn't
even give back a lot over the past month.
It did a big private equity offering at $28. That added to the
stop. It's a range-bound stock until we get incremental drill
results. We think there's a lot of promise there and significant
value for an $11B company. This isn't a tomorrow story, but over
time it will still be a core piece of my portfolio.
Right now we likeSunoco Inc. (SUN:NYSE) , which is transforming
into a general partner (GP) holding company structure akin to a
Kinder Morgan Energy Partners L.P. (KMP:NYSE). Sunoco was a
refining company and held a bunch of different assets. A newer
CEO came in to divest all of the assets. It's a stock that's in
transition. It is currently covered by folks who cover the
refining entities, but in about six months it will be covered by
midstream analysts. So it is going from what was a
sum-of-the-parts restructuring story to a yield-driven GP holding
company, a C-corporation that owns the GP and limited partnership
(LP) interests in a master limited partnership (
) calledSunoco Logistics Partners L.P. (SXL:NYSE) . It will own a
marketing business. This will make it very ratable and not as
volatile as anything else in energy.
While it is restructuring, what is supporting this stock?
It's a yield support based on the value of the underlying assets.
So the value includes the GP and the LP interests in Sunoco and a
4% pro forma dividend yield, versus a current yield of 2%. The
company also has a buyback for 20% of its shares outstanding. We
think that once it gets through the refining sale, it will be
able to reload and buy back another 20% of its stock. The yield
is based on transportation revenues, which is in a steady revenue
stream. The dividend is based on marketing earnings, which is
actually inversely correlated to oil price. In fact, the best
year was 2008, when the oil price went down and the company made
$400M earnings before interest, taxes, depreciation and
amortization. We are forecasting $220M next year. Sunoco already
spun outSunCoke Energy Inc. (SXC:NYSE) , which was $7-8/share.
The stock is really trading around the $45 range, including the
SunCoke distribution. We see almost $10 of upside in the stock.
It is 100% or largely an oil-to-liquids play. The MLP by itself
is attractive. It's a safer type of trade.
Another stock we recommend isHess Corp. (HES:NYSE) . Now we're
moving into something that is going to be more predicated on the
overall commodity price level, primarily the Brent oil price.
Hess is more of a GARPy (growth at a reasonable price) story. The
company has significantly underperformed majors over the last 12
months; a lot of things really went wrong, but we think all those
things will improve going forward. Last year was the wettest year
in history in the North Dakota Bakken, where the company has a
big unconventional growth play, leading to slowed activity.
Weather should be much better this year and that will correlate
to production growth. Hess also suffered from the price
differential situation we discussed earlier. That should
decrease, as should capital efficiency, now that it has set up a
rail system and drilling pad. Although another gas-handling plant
will have to be paid for this year, the billions spent for Utica
acreage will be a net asset value going forward. Finally, the
shift from offshore exploration to higher probability prospects
should pay off in the next 12 months. We are looking at a 2013
growth rate approaching 10%. When things get better, we think it
makes sense to buy. Particularly down here at $55, it's a
price-to-book level, the lowest since 2003.
What's a near-term catalyst for Hess?
An unpredictable catalyst is when the company engages in some
asset sales to fully fund overall capital spending for 2012. The
kicker with a lot of these upstream stocks is that there are few
catalysts that are predictable.
You are followingBonanza Creek Energy Inc. (BCEI:NYSE) . I'm
interested because it's a small-cap stock. What is your opinion
We really like it. It came into the market at a cheap price and
made a lot of operational momentum through the core on the
Niobrara shale formation. Our target price is $23 at this point.
I think it was very inexpensive in the $14 level. We'll have to
see. Its success will depend on how the play develops and how the
company solves some of the variability issues across the
Niobrara, of which we are constructive.
I also coverDelek U.S. Holdings Inc. (DK:NYSE) ,Alon USA
Energy Inc. (ALJ:NYSE) andWestern Refining Inc. (WNR:NYSE) .
Those are all smaller-cap refiners. Delek has a lot of projects.
It's going to help deliver Permian Basin crude into its refining
system, which will be price advantaged. But I think Delek is in a
similar boat, as all the refiners are exiting a period of
significant seasonal strength. A year from now, they will
probably all be at a higher level, but in the short term, we see
Is there anything you love that you haven't spoken about yet?
In refining, I likeHollyFrontier Corp. (HFC:NYSE) . Its earnings
achievability for the full year is the best among all the
refiners. It's essentially paying a special dividend on a
quarterly basis that we believe is sustainable, based on
projected cash flow for the next five years. That yield is
implying a 7.5% overall cash-flow yield. We're going to see $2B
of cash on the balance sheet by year-end. The MLP value is a
little bit under $1B for a stock that is $6B. Its implied
valuation of the assets is significantly compelling. It will be
running 30% WCS. We think that those differentials will remain
the widest for the longest. That will be the last differential
solved as the pipeline capacity begins to build out farther
south. It's a great business with a very disciplined cash return
that's earning the most money with high free cash flow. It's just
a very attractively situated midcontinent asset. The CEO is
buying it under $25/share. Now it is breaching $30/share. This is
one that we would want to buy.
Any final words of advice for investors?
Energy is in a tough spot right now. We believe in refining,
earnings achievability and investing on seasonal weakness.
I've enjoyed meeting you very much, Evan. Thank you for your
Evan Calio is an executive director in equity research at
Morgan Stanley and is the lead analyst for the integrated oil,
large-cap E&P and refining industries. Prior to joining
Morgan Stanley in November 2008, he was energy specialist at JP
Morgan Securities, managing energy risk and proprietary
positions. Before that, Calio was an investment banker at Morgan
Stanley in the Global Energy & Power Group and the Execution
Group, primarily covering refiners, integrated oils and national
oil companies. From 1995-99, Calio was an attorney and a special
counsel for the U.S. Securities and Exchange Commission's
Division of Corporation Finance. He has an Master of Laws (cum
laude) from Georgetown Law Center, a Juris Doctor from the
Widener University School of Law and a Bachelor of Science in
finance from Lehigh University
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