The Bullish Case for Large-Cap Oil Stocks: Fadel
Source: George Mack of
With oil prices near record highs, who are the big winners in
this energy bull market? Fadel Gheit, managing director and
senior analyst of Oppenheimer & Co. has large-cap explorers
and producers on his radar. In this exclusive interview with
The Energy Report
, Wall Street veteran Gheit shares his top picks for
diversification, income and even growth.
The Energy Report:
What is your current investment theme?
I think oil prices are inflated by about 30%, an estimate I've
arrived at using the replacement cost of the marginal barrel
coming from Canada, which would be profitable in the $70-75
range. I see no real reason for oil prices to be significantly
above $80, let alone above $100. That said, I expect oil prices
to remain inflated because of global tension arising from the
situation in the Middle East. As we speak, Brent Crude is around
$122/barrel (bbl). A lot of people do not realize that this is
the highest level of global crude prices for this time of the
year, higher than March of 2008.
What price of Brent are you building into your models through the
end of 2012?
The New York Mercantile Exchange (NYMEX) suggests that crude oil
prices will probably ease going forward. We are estimating 2012
Brent crude oil prices at close to $120/bbl, with West Texas
) close to $107/bbl. WTI will rise slightly whereas Brent will
decline from current levels, with the discount between the two
remaining in the double digits. Hopefully, there will be no
further threats of war in the Middle East.
What are you hearing from institutional investors? Are they
bullish on energy? Are they receiving flows of funds from
It's really a mixed bag. Surprisingly, a lot of investors are not
throwing in the towel on natural gas. They still believe that gas
prices will rebound; the only question is when and by how much.
They see the disparity between oil and gas prices and expect the
two to level out to a degree. However, that will take time. In my
view, natural gas prices will probably be depressed for a lot
longer than many people hope. Nonetheless, at current prices,
long-term upside potential in natural gas is much higher than the
upside potential in crude oil prices.
What is your time horizon for natural gas prices to
I would say three to five years, possibly a couple of years
longer. The current low price and abundance of supply will entice
utilities and other major users to make the switch.
What about the use of natural gas in vehicles?
Natural gas is likely to figure into transportation
infrastructure, namely through compressed natural gas vehicles
and trucks. If new technology and catalysts can be developed and
improved, I think gas-to-liquid is a very strong
possibility.Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) has
completed the largest gas-to-liquid facility in Qatar. It is a
very expensive but improved technology; efficiency and catalysts
can bring this cost down. At $100/bbl for oil, I think gas for
transportation may be competitive if we can reduce capital
In terms of energy efficiency, natural gas is about one-third to
one-fourth the cost of oil. Current research suggests that we
have a 100-year supply of natural gas in North American shales.
Is this myth or fact?
You are probably only scratching the tip of the iceberg. I truly
believe that we probably have four- or even fivefold of what
people think of as the high end of the reserve estimate.
Technology is going to improve recovery rates, which currently
remain very low. If we double or triple the recovery rate over
the next 20 years, that would give us 200 or 300 years of
What price for natural gas would make it economical for companies
Right now, most of the supply sources are not exploited because
they are not economic at $2.40 per thousand cubic feet (/Mcf) in
a market that is already oversupplied. When natural gas prices
exceed $4/Mcf, most of these reserves will be very attractive and
will justify an enormous amount of capital spending. I think that
$4-4.50/Mcf-natural gas will open a lot of new gas reserves to
What does your universe of coverage include?
We cover the large companies, including the majors. We also cover
independent refining and marketing companies and large-cap
exploration and production (E&P) companies such asAnadarko
Petroleum Corp. (APC:NYSE) ,Apache Corporation (APA:NYSE)
,Chesapeake Energy Corp. (CHK:NYSE) ,Devon Energy Corp.
(DVN:NYSE) ,EOG Resources Inc. (EOG:NYSE) ,Hess Corp. (HES:NYSE)
,Marathon Oil Corp. (MRO:NYSE) ,Murphy Oil Corp. (MUR:NYSE)
,Noble Corp. (NE:NYSE) ,Occidental Petroleum Corp. (OXY:NYSE)
andSouthwestern Energy Co. (SWN:NYSE) . In the next few months,
we are going to have a new arrival with the split
ofConocoPhillips (COP:NYSE) into two separate companies. One will
be added to the refining companies universe and the other will be
added to the large-cap E&P companies.
Conventional wisdom says that the majors are tied to the
commodity price, meaning their stock values rise when the energy
commodity price increases. How much truth is there to that
A rising tide lifts all ships. When oil prices rise, oil stocks
usually will move up, and when oil prices go down energy stocks
usually drift lower. The smaller the company, the greater the
reaction to the price movement. Percentage-wise,Exxon Mobil Corp.
(XOM:NYSE) would not move as much as, say, Hess or Murphy or
Apache. There is an inverse correlation between the market cap of
the company and the percentage movement in the stock price in
relation to the commodity price.
Investors often look to juniors for explosive growth. What should
they look for in the fully integrated players, the large E&Ps
and downstream players?
A lot of people say they are investing in energy, but we look at
companies differently. Nobody expects Exxon to grow production by
5%, 10% or 15%. For a very large company, that's unrealistic and
unsustainable, and it does not happen this way. Investors who are
buying the large integrated companies are seeking dividends, less
volatility and efficiency because these companies' growth comes
through improved efficiency and share buyback. Most of the large
companies, especially a company like Exxon, have found a formula.
Because management knows they cannot grow the company by 5%, 6%
or 7%, they buy back their stock at the rate of 2%, 3%, 4% or 5%
annually. It's a way of increasing the valuation per share. At
the end of the day, we don't buy the company, we buy the shares.
So if Exxon buys back 5% of its stock, it hopes that the market
will reward the shares by lifting the share price up by at least
5%. Otherwise, the share buyback would not be successful.
Investors sometimes ask a company if buying back shares is the
best investment it can make with its cash. Do you think that way
when you see a company buying back shares?
Absolutely, but companies have different strategies. For Exxon,
the buyback is part of its business formula. It buys back its
stock consistently. It is not in the business of predicting where
stock prices will be a year from now or five years from now, and
it doesn't look at the stock price. One thing we know for sure is
that by reducing the number of shares, a company improves its
valuation per share, and this is something that nobody can take
away from it.
Fadel, you have already mentioned the threat of war. If tensions
escalate between Israel and Iran, we all know that energy prices
will rise, and that could shock the global economy. How serious
is this threat?
As I mentioned earlier, there is no question in my mind that oil
prices are already inflated by at least 30%. But there is some
justification for this inflation due to fears of potential supply
disruption should war break out between Israel and Iran.
Unfortunately, we might get dragged into a war not of our choice,
because the president is going to be under pressure from the
Republican candidate to act assertively in the situation. This is
just pure politics. But as commander-in-chief, he doesn't want a
third war under his watch when he's trying to wind down one and
the other. Any miscalculation, and the conflict could spread
throughout this region.
A physical supply disruption in any shape or form, whether a
closing of the Straits of Hormuz or a bombing or launching of
missiles from Iran on Saudi Arabia's Ras Tanura terminal, could
result in oil prices like we have never seen before. We could see
$200/bbl oil and gasoline prices of $5-6 per gallon (/gal). It
would destroy any hope of economic rebound and send the global
economy into a deep recession, even bigger than the one we saw in
2008. This is the nightmare scenario that nobody would wish for.
I hope cool heads prevail, and I hope that the president stands
his ground and does not let his detractors push him into another
If oil escalates rapidly, will this hurt energy companies? They
may be getting a higher price per barrel, but consumers will be
buying less. How will this affect them?
Higher oil prices are bad for our economy and bad for the oil
companies themselves, because although they might enjoy a spike
in oil prices momentarily, that would be followed by a very bad
economic situation that in my view would probably take the
financial markets down by 10-15% in a very short period of time.
That would also affect energy stocks, which will go down as much
as the rest of the financial markets.
How can investors diversify against these global macroeconomic
Unfortunately, as in 2008 when we had the market meltdown, there
is no safe place to hide, so it becomes a case of choosing the
lesser of two evils. There could be a flight to quality, as
energy funds find fewer and fewer safe places to hide. That would
normally benefit, relatively speaking, the stocks of major
integrated companies. Basically, investors will seek higher
ground, but everybody will get hurt. I'm better off down 20-30%
than somebody down 50-60%.
Earlier you mentioned your focus on refining stocks. What is
their unique appeal?
We are bullish on the refining and marketing stocks because
although this business will remain volatile, these companies are
in much better shape operationally and financially than at any
time in the last 5 or 10 years. While demand for refined product
continues to decline in developed countries and in the U.S. in
particular, it is growing elsewhere. So even if the demand growth
increases only slightly, we will see accelerated capacity
utilization, especially in the U.S. The market is more
Most of the refining companies in the U.S. have significant
competitive advantages. They have crude oil flexibility, and they
can buy crude cheaper than their competitors outside of the U.S.
because most of their competitors are buying crude at a price
indexed on Brent, which is $20 higher than WTI.
In addition, most U.S. refineries use natural gas to operate,
compared to their competitors outside the U.S., who are using
fuel oil or other more expensive sources. Also, these companies
either increase their dividends, buy back their stock, or do
What refining stocks are on your radar?
We actually like all of them, particularlyHollyFrontier Corp.
(FTO:NYSE) ,Marathon Petroleum Corp. (MPC:NYSE) ,Tesoro
Corporation (TSO:NYSE) andValero Energy Corp. (VLO:NYSE) .
Which large-cap E&Ps do you favor?
We like Anadarko. It's a premier exploration company with a
tremendous track record. Also Apache, one of the fastest-growing
companies, is one of the largest oil producers outside of the
major oils in the U.S. It has a balanced operation between oil
and gas. It is very conservative, and it focuses on costs. It is
opportunistic on acquisitions, and these continue to be very
profitable investments. That's very positive.
We specifically like Hess, Marathon and Murphy. These are
former small integrated companies. They were basically lost in
the crowd when they were compared toBP Plc. (BP:NYSE; BP:LSE)
,Chevron Corporation (CVX:NYSE) or ConocoPhillips. They are
either spinning off their refining and marketing businesses to be
pure E&Ps or selling their refineries, as in the case of Hess
and Murphy. Now they have relatively lower valuations and
increased upside potential. Two-thirds or more of their
production is oil, and one-third is natural gas. They have decent
dividend yields and good balance sheets. In fact, Murphy has more
cash than debt, and although it has had its share of
disappointing drilling results, it will turn the corner. Once it
is successful again, I think the stock is going to rally
significantly-it's only a question of how much.
You mentioned HollyFrontier earlier, another refinery company.
You calculated your $35 target based on a 6.6x 2012 earnings
estimate. That is about half of its peer group multiple of 11.8x.
Why so low?
Actually, we are reviewing our target price because it is very
close to it now. Again, this is a company that continues to buy
back stock, continues to increase dividends and pays special
dividends. It's locked into the midcontinent, where it has access
to much more discounted crude than anybody else. It's an area
that I think is going to be advantaged by the increased supply
from all the unconventional oil plays and its ability to access
all kinds of crude oil. The stock has done very well. It has been
the best-performing stock in the last couple of years. I think
the trend will continue.
It's doing everything, literally. When a stock is moving fast
like HollyFrontier, your dividend yield obviously goes down.
That's not because it is cutting the dividend. But there is a
speed limit: How high can you go, and how fast can you grow the
dividend? Obviously, you cannot just keep growing the dividend
every time something happens. There is nothing worse than
companies cutting their dividends. It is also not good if you
leave the dividend unchanged for a long period of time, because
you then lose the lure of dividend growth. It's not the yield
that moves the stock, but the growing dividend. When a company
increases its dividend, it is basically sending a message to
investors that management is confident in the financial outlook
of the company.
Staying on yield for a moment, there are two companies in your
coverage with nice yields, Royal Dutch Shell and BP. Shell's
dividend is about 4.7%, and you have a target price of $85 on the
stock, which represents a very nice implied upside of 20%. You
have written that new investment and enhancements are expected to
dramatically increase cash flow by 50% between 2012 and 2015
compared to the previous three-year period. Why such an
Many companies, especially Shell, have a very large number of
projects spread over the next three or four years. These are
multibillion-dollar projects that have been in the works for many
years but have not yet contributed production, cash flow or
earnings. However, once they hit their stride, these projects
will boost cash flow by almost 50%. At that point, the company
and shareholders are basically collecting the fruit.
BP has a nice yield of around 4%, and it is actually up 27% over
the past six months. After the announced settlement of $7.8
) for economic damages on March 2, the stock reacted positively
for a day, but nothing to write home about. Would you have
expected a bigger jump after that agreement?
It's not time for the cigar yet because it's not over. There is
potential liability, as high as $20B with regard to the Clean
Water Act. I think most investors cheered the news on March 2 but
exaggerated the impact because the bigger liability is still yet
to come. It is a step in the right direction. It shows clearly
that BP is making progress. It reduced its risk and that in
itself is positive. But that doesn't mean it's home free. It is
far from it.
You have a $55 target price on BP, which represents very good
upside from current levels.
Correct, but it also has the largest risk, to tell you the truth.
The $55 price target assumes that BP is not going to be found to
have committed gross negligence. The difference between no gross
negligence vs. gross negligence could be as much as $17B,
equivalent to more than $5 in the stock price. That's
substantial. We are building a case based on three government
investigations around the BP well blowout in the Gulf and
settlements with other partner companies like Anadarko, Mitsui
& Co. Ltd. (MITSY:NASDAQ), Weatherford International Ltd.
(WFT:NYSE) and Cameron International Corp. (CAM:NYSE). Federal
investigators found no gross negligence. It was the most
unfortunate accident but it was multiple breakdowns in
communications that resulted in the accident. Now, if BP loses
its court battle with the Department of Justice and the state and
local governments, then obviously all bets are off. But, again,
I'd say there's a very high probability that BP will probably get
this dark cloud removed and settle all outstanding lawsuits at or
within the current budget estimate of $37B.
You just increased your target price on Devon Energy Corp. from
$80 to $90, but your valuation multiple is still below its peer
group averages. What is your investment theory here?
This is a company that is very well run. It sold most or all of
its interests offshore to focus on onshore plays. The rise in the
target price basically reflects its recent joint venture, which
in my view is going to be the beginning of an accelerating
You raised your target price on EOG from $120 to $140 to reflect
generous reserves in the Eagle Ford. When might we see production
growth materialize from these assets?
Companies are accelerating their drilling activities and
development in all these plays because it's very profitable
relative to natural gas. EOG is growing its oil production and
liquids by 30% this year. Next year most of its revenue is going
to be coming from the oil and the liquids, and less and less from
natural gas. But what really triggered the target price increase
was the expansion in the Eagle Ford's potential reserve. That is
a significant development, and it is the largest play in terms of
increased production and reserves. It was the biggest in the
Bakken, but now it is making the Eagle Ford its biggest play.
It's much oilier and has much larger reserves than ever before,
yet the stock is still trading 20% beneath its price five years
ago. I'm very positive.
EOG is up 30% over the last six months. Do you think of this as a
value or a growth play?
It's a combination. It's a very interesting question because when
you come to think of it, the gas companies that are becoming
oil-focused really should be ranked on liquids growth, not gas
growth. By putting their emphasis on oil, they are creating
value. So I think this is a profitable growth story, and over the
next two or three years, you are going to easily see double-digit
production growth in a very profitable environment if oil prices
remain even in the $80-$90/barrel range.
Southwestern Energy is a pure U.S. onshore gas play, and clearly
it has suffered because of that. Does the company have to wait
for gas prices to recover, or is there another avenue for the
It's a very well-run company. Even given low natural gas prices,
it still maintains a very decent balance sheet. It pays no
dividend. Breakneck speed growth production of 20-30% per year
for the last 10 years when gas prices were positive is obviously
not sustainable. The company is definitely looking at other
opportunities and other options.
Fadel, thank you for taking this time. It's been very valuable
Excellent, thank you.
Fadel Gheit is a managing director and senior analyst
covering the oil and gas sector. He spent six years with Mobil
Oil and five years with Stone & Webster. He has been an
energy analyst since 1986 with Mabon Nugent and JP Morgan and has
been with Oppenheimer & Co. Inc. since 1994. He has been
The Wall Street Journal's
All-Star Annual Analyst Survey four times and was the
top-ranked energy analyst in the
Annual Analyst survey for four years. He is one of the most
quoted analysts on energy issues and has testified before the
U.S. Senate and the U.S. House of Representatives about oil price
speculation, and is a frequent guest on TV and radio business
programs. Gheit holds a Bachelor of Science degree in chemical
engineering from Cairo University and a Master of Business
Administration degree in finance from New York University.
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1) George Mack of
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conducted this interview. He personally and/or his family own
shares of the following companies mentioned in this interview:
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3) Fadel Gheit: I personally and/or my family own shares of the
following companies mentioned in this interview: BP Plc, Chevron
Corp, Exxon Mobil Corp., Royal Dutch Shell Plc and Devon Energy
Corp. I personally and/or my family am paid by the following
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