Oil & Gas Stock Outlook - Sept. 2012 - Industry Outlook

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OUTLOOK

Crude Oil


The Federal Reserve's pledge towards a new round of economic stimulus, a tightening global supply picture in view of the ongoing unrest in the resource-rich Middle East and a German court's green light to the Eurozone bailout fund have strengthened oil prices to around mid- to upper $90s a barrel. Partly offsetting this favorable view has been high U.S. crude stocks and worries about China's growth outlook.

The long-term outlook for oil, however, remains favorable given the commodity's fairly positive demand picture. In particular, while the Western economies exhibit sluggish growth prospects, global oil consumption is expected to get a boost from sustained strength in the non-OECD (Organization for Economic Cooperation and Development) countries that continue to expand 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 an estimated 1.0 million barrel per day in 2011 to a record-high level of 88.3 million barrels per day. In 2010, oil demand increased by over 2 million barrels per day to 87.3 million barrels per day, which more than made up for the losses of the previous 2 years, and surpassed the 2007 level of 86.3 million barrels per day (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 0.8 million barrels per day in 2012 and 1.0 million barrels per day in 2013. EIA's latest forecasts assumes that demand will be lackluster in U.S., Europe and Japan but this will be more than made up by impressive consumption surge coming from Russia, 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 will increase by 0.8 million barrels per day annually, reaching 88.7 million barrels a day in 2012 from last year's 87.9 million barrels a day. In 2013, OPEC expects world liquid fuels consumption to grow by another 0.8 million barrels per day to average 89.5 million barrels per day.

Lastly, the third major energy consultative body, the Paris-based International Energy Agency (IEA), the energy-monitoring agency of 28 industrialized countries, also said that it expects world oil consumption to grow by 0.8 million barrels per day during both 2012 and 2013 to average 89.8 million barrels per day and 90.6 million barrels per day, respectively.

In our view, crude oil prices in the remainder of 2012 are likely to exhibit a sideways-to-bullish trend. 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 evident.

As long as growth from 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 world population of 7 billion people and all the easy oil being already discovered and expended, we assume that crude will trade in the $90-$100 per barrel range for the near future.

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 some 10% above the benchmark levels -- are at their highest level for this time of the year, reflecting robust onshore output.

To make matters worse, near-record mild winter weather across most of the country curbed natural gas demand for heating, leading to an early beginning for the stock-building season. The grossly oversupplied market continued to pressure commodity prices in the backdrop of sustained strong production.

This prompted natural gas prices to dive approximately 63% from the 2011 peak of $4.92 per million Btu (MMBtu) in June to a 10-year low of $1.82 per MMBtu during late April 2012 (referring to spot prices at the Henry Hub, the benchmark supply point in Louisiana ).

However, in the recent past, repeated smaller-than-average storage builds have rallied back prices toward $3.00 per MMBtu. As hot summer weather prevailed across the country, homes and businesses were prompted to increase electricity draws to run air conditioners.

But with temperatures falling from their summer highs and consequent cooling demand set to wane, bigger storage builds are likely to prevail in the near future. In fact, the EIA foresees natural gas storage at all-time highs of around 4.0 trillion cubic feet by October's end.

Moreover, there are apprehensions that should natural gas breach and stay above the $3.00 per MMBtu barrier, utilities that took advantage of the beaten down prices to switch to the commodity from the more costly coal, could revert back to the latter. This demand loss may further inflate natural gas inventories.

Therefore we do not expect much upside in gas prices in coming weeks. In other words, there appears no reason to believe that the supply overhang will subside and natural gas will be out of the dumps in 2012.

OPPORTUNITIES

Considering the turbulent market dynamics of the energy industry, we always advocate the relatively low-risk conglomerate business structures of the large-cap integrateds, with their fortress-like 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.

Within the oilfield services group, we like National Oilwell Varco Inc. ( NOV ). We are a fan of National Oilwell's healthy backlog, solid balance sheet and strength in international operations, particularly in the Middle East and Brazil. The impending Robbins & Myers Inc. ( RBN ) acquisition will further boost National Oilwell's earnings visibility by expanding its blowout preventer product line; a critical safety machine for a well. The recent influx of offshore rig awards adds to the positive sentiment.

Buoyed by the favorable trends in the refining sector, we are more optimistic on the industry than we were 12 months ago. An uptick in economic activity overseas (mainly in developing countries) and prospects for higher fuel demand in the U.S. are likely to push 2012 industry margins higher than last year's levels. Against this backdrop, we are particularly bullish on Tesoro Corp. ( TSO ) and Western Refining Inc. ( WNR ).

Tesoro's decision to resume dividend payout and the announcement of a $500 million share buyback program make us optimistic about the company. Our positive stance also revolves around Tesoro's proposed acquisition of British energy giant BP plc's ( BP ) Southern California refinery, which, apart from boosting refinery capacity, will also improve the company's operational efficiency. An uptick in crack spreads and Tesoro's scale and diversification benefits afforded by its portfolio of seven refineries add to the positive sentiment.

On the other hand, we believe Western Refining's strategic actions -- to improve its performance and competitiveness in a cost-effective manner -- will drive growth in the company's profits and boost its stock valuation. Western Refining's strong retail and wholesale operations, along with exposure to the profitable Southwest refining assets, are some other catalysts.

Schlumberger Ltd. ( SLB ), the world's largest oil services firm, is also a top pick. We believe Schlumberger's combination of balance sheet strength; technological leadership and management depth will be beneficial in the long term. We also believe the company is favorably positioned to benefit from current trends in oilfield services, given improving activity levels and greater need for stimulation and completion of services in North America.

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 recommend avoiding ConocoPhillips ( COP ), one of the six supermajor oil companies. Following the recent spin-off of its refining/sales business into a separate, independent and publicly traded company Phillips 66 ( PSX ), ConocoPhillips is now totally dependent on its upstream portfolio that offers lackluster volume growth prospects. Moreover, the transfer of the downstream operations (post-split) has left the Houston, Texas-based firm with a less diversified business.

We are bearish on Brazil's state-run energy giant Petroleo Brasileiro S.A. ( PBR ), or Petrobras S.A. Following the company's dismal second quarter showing, we see little reason for investors to own the stock. The Rio de Janeiro-headquartered group recently posted its first quarterly loss in 13 years on the back of a weak domestic currency, rising costs and heavy fuel imports. We also remain concerned by Petrobras' huge investment requirements, the possibility of heightened state interference and caps on local fuel prices.

We are also skeptical on leading North American energy firm Williams Companies Inc. ( WMB ). In particular, we remain wary of low natural gas prices, which are likely to restrict near-term growth prospects at Williams. Additionally, we believe that transfer of the upstream assets (post-split) has left Williams with a less diversified business.

As a result, the business risk profile of the reorganized Williams is weaker than that of the pre-spin-off company. Lastly, we remain concerned about Williams Companies' high debt levels, which leave it vulnerable to an extended drop in commodity prices. As of June 30, 2012, Williams had debt of over $9 billion, representing a debt-to-capitalization ratio of more than 60%.

Based upon the number of near-term challenges, we remain pessimistic on the near-term prospects of Nabors Industries Ltd. ( NBR ). The land drilling contractor is facing headwinds in the pressure pumping market on the back of collapsing prices and lower utilization. The recent weakness in the North American onshore rig count has also been a negative.

As usual, we remain concerned about weak natural gas fundamentals, which are likely to limit the company's ability to generate positive earnings surprises. Nabors' fairly debt-heavy balance sheet also remains an issue. Considering these factors, we see Nabors as a risky bet from which ordinary investors should exit.

Chinese refining giant China Petroleum and Chemical Corporation ( SNP ) -- also known as Sinopec -- is another company we would like to avoid for the time being, mainly due to slower domestic growth. Moreover, increases in the price of international crude oil - amid government caps on fuel prices - has been preventing the company from fully passing on spiraling costs to consumers, and thereby hurting refining margins.

Lastly, we expect ADRs of South African petrochemicals group Sasol Ltd. ( SSL ) to be under pressure in the near future. While approximately 60% of Sasol's operations are based in South Africa , about 90% of its sales are either denominated in dollars or are influenced by the global commodity and benchmark prices, which are quoted in dollars. As such, the group is exposed to risks associated with an unfavorable rand-dollar exchange rate.

Moreover, Sasol's quest for its flagship coal-to-liquids (CTL) and gas-to-liquids (GTL) projects are expected to stretch its medium-term returns significantly, as the company would have to employ a considerable amount of nonperforming capital on its balance sheet until start up.


 
BP PLC (BP): Free Stock Analysis Report
 
CONOCOPHILLIPS (COP): Free Stock Analysis Report
 
CHEVRON CORP (CVX): Free Stock Analysis Report
 
EOG RES INC (EOG): Free Stock Analysis Report
 
NABORS IND (NBR): Free Stock Analysis Report
 
NATL OILWELL VR (NOV): Free Stock Analysis Report
 
PETROBRAS-ADR C (PBR): Free Stock Analysis Report
 
PHILLIPS 66 (PSX): Free Stock Analysis Report
 
ROBBINS & MYERS (RBN): Free Stock Analysis Report
 
SCHLUMBERGER LT (SLB): Free Stock Analysis Report
 
CHINA PETRO&CHM (SNP): Free Stock Analysis Report
 
SASOL LTD -ADR (SSL): Free Stock Analysis Report
 
TESORO CORP (TSO): Free Stock Analysis Report
 
WILLIAMS COS (WMB): Free Stock Analysis Report
 
WESTERN REFING (WNR): Free Stock Analysis Report
 
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Investing Ideas , Stocks

Referenced Stocks: BP , COP , CTL , CVX , EIA

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