Black Gold, Or Booby Prize?

12/1/2014


Oil's price movements have confounded investors since the fuel was first used to illuminate lamps in the late 1850s. The nascent U.S. oil industry, which sprang up in Western Pennsylvania, would see per-barrel prices swing from $10 to $0.10 within the same calendar year. Sometimes, the barrels cost more than the oil they contained.

At the end of October 2014, U.S. oil production stood at its highest level in at least three decades. However, U.S. producers have become victims of their own success. Since May, the Organization of the Petroleum Exporting Countries (OPEC) has ramped oil production, widely viewed as an attempt to shake out the small U.S. shale drillers. OPEC controls about one-third of the world's oil.

Based on the West Texas Intermediate (WTI) benchmark, U.S. oil prices of less than $76 a barrel are more than 30% off their June peak and near their lowest level since September 2010. Since the great recession, oil prices have experienced two similar sell-offs — in the summers of 2011 and 2012, when prices plunged 34% and 29% from their respective peaks.

The 2011 drop in oil prices did not dampen drilling activity, as the number of oil rigs in North America continued to climb. In 2012, the rig count held up fairly well while prices were soft, then proceeded to decline about 8% over the following six months.

As of Nov. 21, the rig count of 1,929 is just one below the record high set on Oct. 10.

Improved efficiency from new drilling techniques means many companies can keep growing with fewer rigs. Moreover, 96% of North America's oil and natural-gas liquids projects have breakeven prices below $80 a barrel, according to the International Energy Agency, though the percentage is probably much lower among projects launched in the last year. More than 80% of projects remain profitable with oil below $60 a barrel, says the IEA.

In the past month, several oil producers talked about keeping capital budgets within their cash flow, a prudent approach. Lower oil prices could put substantial pressure on cash flows, shrinking these firms' capacity for investment. Continental Resources ($54; CLR) and Apache ($73; APA) have lowered their 2015 budgets for capital spending, and EOG Resources ($97; EOG) has hinted about it.

Drillers plan to pursue solid production growth in the year ahead by relying on their most profitable oilfields and scaling back on projects with lower rates of return. With fewer drilling sites in operation, oilfield-services companies and rig operators risk getting squeezed on both prices and volumes.

Acting on those concerns, Halliburton ($48; HAL) agreed to acquire Baker Hughes ($63; BHI). Halliburton expects the $34.6 billion deal, announced in November, to yield annual cost savings of $2 billion, in addition to boosting its market power.

Low prices are unlikely to significantly deter production and investment — if the declines prove temporary. In contrast, many industry players expect a material contraction if oil prices remain weak into 2015.

Interestingly, some OPEC countries, struggling to balance their budgets, may experience the most discomfort from living with low oil prices. Nevertheless, OPEC may be prepared to withstand prices as low as $70 to $80 for up to a year. OPEC meets on Nov. 27, after our deadline, to consider its next move.

INDUSTRY ANALYSIS
The S&P 1500 energy sector looks inferior to the broader index based on recent returns and 12-month profit growth. Plus, 86% of stocks in the sector now have a lower consensus profit outlook for the upcoming fiscal year than they did 30 days ago, compared to 53% for the S&P 1500 Index.
3-Mo.
Total
Return
(%)
Per-Share
-- Profit Change --
----- P/E Ratio -----
30-Day Chg. To
Est. EPS For
Next Fiscal Year
Industry (No. Of Cos.)
Last 12
Months
(%)
Next 12
Months,
Est.
(%)
Trailing
Forward
% Of
Stocks
Up
% Of
Stocks
Down
Coal & consumable
fuels (4)
(15)
(18)
(9)
56
36
0
100
Integrated oil &
gas (4)
(10)
(2)
(22)
13
18
0
100
Drilling (12)
(28)
(5)
2
13
10
17
83
Equipment &
services (29)
(15)
7
14
21
16
7
86
Exploration &
production (36)
(22)
3
(8)
21
24
6
94
Refining &
marketing (7)
(2)
11
12
12
11
14
71
Storage & transport.
(4)
(5)
(16)
15
39
33
50
25
S&P 1500 energy
sector (96) avg.
(18)
3
2
20
19
9
86
S&P 1500 avg.
3
7
11
23
21
36
53

In their own words

We can learn a lot about the state of the energy sector based on executives' comments from September-quarter earnings calls.

Equipment & services

Halliburton ($48; HAL) from Oct. 20 (when West Texas Intermediate crude closed at $83 a barrel).

"I am not going to predict what the oil price is going to be, but on a longer term, we believe industry fundamentals suggest that these lower prices are not sustainable," said CEO David Lesar. "Nevertheless, we are keenly aware that there is a risk of a moderation in activity if oil prices remain weak for an extended period of time. . . . What I can tell you is that in recent conversations with our North America customers, we have not received any indication of activity levels slowing as we transition into 2015 . . .We believe oil prices will have to remain at lower levels for a sustained period before the long-term economics would begin to impact our primary customers." At the same time, Halliburton expects international oil customers to trim capital budgets. Halliburton is a Buy and a Long-Term Buy.


Schlumberger ($95; SLB) from Oct. 17 ($83).

Schlumberger notes that the U.S. Energy Information Agency expects global oil demand to rise 1% in 2015. "So with the growth in demand for next year, we believe that there has to be increased spending levels. Where this spending is going to take place, I think, is going to be a function of where the oil price stabilizes," said CEO Paal Kibsgaard. "So the main focus that we have now is to pass on the cost inflation that we have from our supply chain to our customers. I think the appetite from our customers will be lower in terms of how much of the further cost increases they're willing to take." Schlumberger is a Focus List Buy and a Long-Term Buy.


Baker Hughes ($63; BHI) from Oct. 16 ($82).

"If we just look at the core most successful customers — I think $75 is the starting point to where activity could start to slow," said CEO Martin Craighead. "The second very big variable to that is the duration . . . so (if) we would see $75 next week, I don't think you're going to see one iota of activity slippage. But if we're sitting at $75 come the holiday season or early into the first quarter, then certainly I think the conversations with the customers will be different." Baker Hughes is not rated.

Exploration & production

Whiting Petroleum ($55; WLL) from Oct. 30 ($81).

"If oil prices recover and we have more cash flow, we can scale up our plan and grow faster," said CEO James Volker. "But the point we're trying to emphasize is that at current oil prices, we can achieve something similar to this year's (production) growth rate, we think, around 20%." Whiting does not anticipate much change if prices fall to $75 or $70 a barrel. Management expects the 2015 capital budget to resemble combined 2014 spending levels for Whiting and Kodiak, the $6 billion acquisition Whiting plans to complete in December. Whiting is a Buy and a Long-Term Buy.


Apache ($73; APA) from Nov. 6 ($78).

"We've got a real sea change in oil prices. I think we're all going to have a look at how we run businesses at $80 oil in North America, and without blowing out the balance sheet," said CEO Steve Farris. "So depending on what happens to oil prices . . . our capital program is going to be somewhere around what our cash flow is going into 2015."

Just two weeks later, Apache lowered its 2015 spending budget in North America by 25% to $4 billion. Apache is rated B (average).


Chevron ($116; CVX) from Oct. 31 ($81).

"We take a long-term view on prices," said CFO Pat Yarrington, adding that Chevron will maintain its long-term production targets. Chevron may reduce discretionary spending but plans to keep funding its massive Gorgon and Wheatstone projects in Australia, while development in the Permian fields in the U.S. "remains quite attractive even at lower prices." Chevron is rated B (average).


Continental Resources ($54; CLR) from Nov. 6 ($78).

"We do expect crude oil prices to strengthen to the mid-80s or $90 range over the short term," said CEO Harold Hamm. "We feel like we're at the bottom rung here on prices, and we'll see them recover pretty drastically, pretty quick." Continental has sold almost all of its hedges through 2016 in anticipation of a sharp rebound in oil prices. But it also trimmed its 2015 capital spending budget and rig count guidance. Continental lowered its 2015 production target but still expects growth of 23% to 29%. These new targets assume oil prices at $80 a barrel. Continental is rated B (average).


EOG Resources ($97; EOG) from Nov. 5 ($97).

"Our large, high-quality drilling portfolio still generates exceptional returns with $80 oil," said CEO Bill Thomas. EOG said that at $80 a barrel, it planned to maintain drilling projects in Eagle Ford and Delaware Basin (Texas), and in the Bakken (North Dakota), which generate after-tax rates of return of 100% or more at that price. Even at $40 a barrel, these three locations produce a 10% return. EOG is rated A (above average).    


Exxon Mobil ($95; XOM) from Oct. 31 ($81).

"These near-term price fluctuations are not going to have an impact on our operational activities," said Jeffrey Woodbury, vice president of investor relations. Exxon is rated B (average).

A-RATED ENERGY PLAYS (BUYS IN BOLD)
Total Return
--- 12-Month Change ---
---- P/E Ratio ----
------ Quadrix Scores ------
Company (Price; Ticker)
3
Months
(%)
YTD
(%)
Sales
(%)
EPS
(%)
Est. EPS,
Next 12
Months
(%)
Trailing
Forward
Momen-
tum
Value
Overall
Industry
EOG Resources
($97; EOG)
(10)
16
25
NA
(7)
19
20
76
75
87
Explor. & production
Halliburton ($48; HAL)
(29)
(4)
9
31
23
13
10
56
94
87
Equipment & svcs.
National Oilwell
($72; NOV)
(14)
3
12
16
4
12
12
64
96
88
Equipment & svcs.
Occidental Petroleum
($86; OXY)
(16)
(7)
0
21
(24)
13
17
18
83
58
Integrated oil & gas
Schlumberger ($95; SLB)
(13)
7
8
21
13
18
16
60
79
84
Equipment & svcs.
Valero Energy ($51; VLO)
(5)
3
0
43
(8)
8
8
94
99
99
Refining & mktg.
Whiting Petroleum
($55; WLL)
(40)
(11)
21
7
(16)
12
14
35
86
65
Explor. & production
Note: Quadrix scores are percentile ranks, with 100 the best. 

 


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