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Issues

Chemical Reaction

One of the most important features of the US shale oil and gas revolution has been the rolling wave of oversupply that has moved through the energy value chain, creating market imbalances and distorting long-standing price relationships between various hydrocarbons.

Over the past several years, oil and gas companies’ overzealous production of natural gas and natural gas liquids has restored the fortunes of domestic petrochemical producers, an energy-intensive industry that relies on these commodities to generate power and as feedstock.

Within this space, olefin producers have benefited the most thus far, thanks to extraordinarily low feedstock prices. But the multiyear boom in profit margins for US polyethylene producers appears to be winding down, with the baton of profitability likely to move further downstream.

Midyear Outlook: Top-Down View

At the end of 2016, Wall Street analysts’ median forecast called for West Texas Intermediate (WTI) to average $56 per barrel in the third quarter of 2017 and for Brent to approach $60 per barrel by early 2018.

Whereas most investors cheered OPEC, Russia and a handful of other oil-producing countries’ “historic” agreement to cut output, we took a less sanguine outlook in an Alert issued on Dec. 12, 2016:

OPEC would lose credibility next year as the regulator of the global oil market. Meanwhile, WTI will range between $40 and $60 per barrel for at least the next two to three years. In the near term, we continue to expect WTI to tumble to less than $40 per barrel, once these realities become apparent.

In subsequent writings, we called for oil prices to spend much of the next two years between $45 and $55 per barrel, with spikes outside that range ultimately proving to be relatively short-lived.

This macro view has played out thus far, with sentiment on the efficacy of OPEC’s production cut beginning to sour in March, reflecting concerns about the rapid growth in US oil output in the first half of 2017. Against this backdrop, WTI tumbled to about $42 per barrel in June, before enjoying a modest oversold bounce.

With second-quarter earnings season set to begin in earnest later this month, we update take advantage of the pause before the deluge to review and update our outlooks for commodity prices and energy stocks.

International Opportunities

After updating our commentary and ratings for the more than 80 stocks in our International Coverage Universe, we continue to favor midstream names that offer exposure to volumetric growth stories and our top bets on renewable energy. All offer above-average yields that should juice investors’ total returns.

Even better, Canadian pipeline owners have operated more conservatively than their US counterparts and boast stronger balance sheets.

Ongoing takeaway constraints mean that crude oil, natural gas, and natural gas liquids produced in Alberta continue to fetch significantly lower prices than their US benchmarks. These wide price differentials represent a headwind for Canadian oil and gas producers, but underscore the opportunity set for midstream operators.

The Lay of the Land

After OPEC and other major oil-producing countries agreed to curb production in fall 2016, specialist and generalist portfolio managers alike bet heavily on West Texas Intermediate (WTI) rallying to at least $60 per barrel this year.

This shot of confidence prompted investors to move down the quality chain in the search for value and alpha, with marginal equities rallying hard and high-yield energy bonds acting as though the 2014 collapse in oil prices was an aberration, never to be repeated.

However, in 2017, the story has shifted to how the surge in US oil output and stepped-up drilling and completion activity in prolific shale plays—abetted by upstream operators’ aggressive hedging when WTI fetched more than $50 per barrel—have threatened to overwhelm the extended OPEC and non-OPEC supply cuts.

Two weeks of disappointing data on US oil and refined-product inventories have reinforced the market’s negative sentiment toward WTI and energy stocks, while the International Energy Agency’s most recent forecast called for growth in non-OPEC output—led by the US—to offset projected growth in global demand next year.

A string of bullish inventory reports from the Energy Information Administration with larger-than-expected drawdowns in crude and refined-product inventories—a distinct possibility during the summer driving season, a period of strong demand—could catalyze a near-term pop in energy stocks and oil prices.

But ultimately the market will need to come to grips with a US onshore rig count that has increased by 425 drilling units since May 2016 and the Energy Information Administration’s (likely conservative) projections that domestic oil output will increase by an average of 340,000 barrels per day this year and 500,000 barrels per day in 2018.

At this point in the recovery, the US onshore rig count sits at levels (about 900) that Halliburton’s (NYSE: HAL) former CEO, Jeff Miller, last year asserted would have the equivalent productivity of about 2,000 drilling units at the previous cycle’s peak.

Barring further supply cuts from OPEC or security-related disruptions, oil prices could adjust to levels—potentially in the $30s per barrels—that would prompt the US shale complex to rein in drilling and completion activity.

A decline in the US onshore rig count would be the first sign of a US response, while a moderation in the pace at which the industry works off the inventory of drilled wells awaiting completion would also help.

Despite the near-term uncertainty and volatility in the energy sector, we can draw several firm conclusions from developments during the previous down-cycle and the recent up-cycle that will inform our investment strategy in the near term and long term.

Evaluating Recent Energy IPOs

After a prolonged lull ushered in by the collapse in oil prices and reduced drilling and completion activity in the US, the flow of initial public offerings (IPO) in the energy sector has increased in recent months, with private-equity outfits seeking to monetize investments in the upstream and oil-field-service segments.

In particular, this year has ushered in a bumper crop of IPOs focused on pressure pumping—the horsepower that forces the fracturing fluid into the reservoir rock—and related downhole services. The timing of these deals coincides with expectations for increasing demand, as exploration and production companies ramp up their completion activity in prolific US shale plays.

However, not every prospective debutant made it to the market on time, with a difficult tape prompting Liberty Oilfield Services (NYSE: BDFC) to postpone its IPO. Investors should tread carefully with these highly cyclical names that specialize in highly commoditized products and service lines; near-term volumetric upside from stepped-up completion activity aside, history suggests that any pricing traction will prove short-lived.

Within the upstream space, the trend toward IPOs involving recycled acreage in the Eagle Ford Shale and revivified Haynesville Shale demonstrates how one company’s noncore assets can become a new holder’s crown jewel, with the appropriate attention and a reset cost basis.

These transactions underscore the scope of the resource base in the US and why the competition for market share will only intensify—an environment that favors players with the strongest balance sheets, highest-quality acreage and lowest cost basis.

Within the midstream segment, the recent crop of IPOs has come primarily from upstream operators seeking to monetize assets. Potential upside for these master limited partnerships usually hinges on a combination of drop-down transactions and increasing throughput volumes, with the market preferring names weighted toward organic growth.

Here, investor must remain laser-focused on the sponsor’s motivations, balance sheet and growth prospects in an environment where energy prices remain lower for longer.

US Shale: Pump Up The Volumes

Every earnings season, we pay particularly close attention to commentary from the major oil-field service companies—Schlumberger (NYSE: SLB), Halliburton (NYSE: HAL), Baker Hughes (NYSE: BHI) and Weatherford International (NYSE: WFT)—because their extensive operations give them insights into key trends throughout the energy value chain.

Their conference calls also occur relatively early each earnings season; the read-throughs gleaned from the proceedings can provide insight into emerging opportunities and potential pitfalls.

Although we continue to pore over first-quarter results from the energy patch, comments from management teams in the upstream and oil-field-services industries underscore the potential for further efficiency and productivity gains in US shale plays.

Given the short development times needed to exploit these resources, drilling and completion activity in the US onshore market will continue to track oil price realizations and producers’ ability to hedge future output. These fluctuations will create investment opportunities in cyclical names, but timing will be crucial.

Our outlook for oil prices to remain lower for longer and the best US shale plays to take market share favors an overweight position in midstream master limited partnerships, especially those with the best-positioned assets, capable management teams and healthy balance sheets.

Permania And MLP Madness

The Energy & Income Advisor team has recovered from the DUG Permian Basin conference, which we attended in Fort Worth, Texas. Readers can find our top takeaways and best investment ideas from the event in the slide deck and video presentation that we put together earlier this month.

As we mentioned in our presentation, we left the conference impressed with the quality of the stacked resource base in the Delaware and Midland basins, plays that we expect to continue to take market share over the long run because of their superior economics and ample midstream infrastructure. Our Focus List and Model Portfolios include a number of names that offer exposure to this growth story, though we prefer the midstream segment in the current environment.

With the DUG Permian Basin Conference done and dusted, our focus shifts to first-quarter earnings season and the MLP Association’s annual investor conference—an event that gives us an opportunity to put management teams through their paces and talk shop with analysts and portfolio managers. Historically, this conference has produced a good crop of investment ideas.

In preparation for earnings season and this event, we went through the exhaustive (and frequently exhausting) process of updating our comments for all the names in our MLP Ratings table. For your convenience, we have appended the results to the PDF of this issue.

Northern Exposure

Canadian oil and gas producers continue to contend with lower price realizations than their counterparts south of the border, reflecting intensifying competition from US shale plays and, in the case of crude, takeaway constraints.

This challenging environment means that investors should place a premium on quality and remain disciplined.

In the upstream space, Canadian Natural Resources (TSX: CNQ, NYSE: CNQ) and Suncor Energy (TSX: SU, NYSE: SU) continue to consolidate and build economies of scale as integrated oil companies and diversified independents seek to monetize their oil-sands assets.

Based on current valuations and the macro outlook, we continue to prefer best-in-class midstream operators and power producers for investors looking to add exposure to Canada’s energy patch. Many of our favorite Canadian midstream players also tend to trade with less volatility than their peers in the US.

More important, Alberta’s Climate Leadership Plan, which calls for the province shutter its coal-fired power plants by 2030, creates a longer-term opportunity for low-cost natural-gas producers and midstream operators to grow their volumes. We break down the names that are best-positioned to take advantage of this shift. Investors should also check out our International Coverage Universe for update comments and ratings.

Alternative Fracks

Fourth-quarter results and 2017 guidance from the big four oil-field service companies—Schlumberger (NYSE: SLB), Halliburton (NYSE: BHI), Baker Hughes (NYSE: BHI) and Weatherford International (NYSE: WFT)—highlighted recovering drilling and completion activity in the US onshore market and ongoing challenges in international markets.

Once again, the prospect of increased upstream capital expenditures appears most robust in prolific US shale oil and gas fields, where exploration and production companies have taken advantage of the recovery in oil prices to hedge future output and ramp up spending.

The Permian Basin in West Texas may be the hottest area in terms of drilling activity, asset acquisitions and media coverage. That said, the recovery in the US rig count looks broader that one might expect, with the formerly out-of-favor Eagle Ford Shale and the Haynesville Shale posting surprisingly impressive gains.

In contrast, international capital expenditures are expected to remain flat to slightly down in 2017, with the Middle East and Russia regarded two markets with any upside.

Although we struggle to identify a compelling reason to buy any of the big four at current valuations, recent weakness in the energy sector—and questions from readers—have prompted us to delve into names that offer concentrated exposure to the US onshore market.

The bullish case for US oil-field services hinges on accelerating drilling and completion activity helping to relieve the capacity overhang built up during the boom years, potentially setting the stage for a recovery in pricing.

Industry survivors with superior scale and balance sheets may have an opportunity to take market share from smaller operators. Oil-field service companies have also slashed costs aggressively, providing earnings leverage to a recovery in volumes.

At the same time, investors must remember that many of these companies operate cyclical businesses and consider the extent to which current valuations have priced in any incremental upside in earnings.

We continue to expect short-cycle US shale plays to take market share in coming years, as underinvestment in deepwater plays and other complex developments manifests itself in the international decline rate. Chevron Corp (NYSE: CVX) and Exxon Mobil Corp’s (NYSE: XOM) plans to allocate a growing portion of their budgets to US shale development underscore this point.

Midstream Focus And An Upstream Update

A little over a year ago, we added three high-quality oil and gas producers to the model Portfolio. Our selection process targeted names with strong balance sheets, low production costs, a history of solid execution and franchise assets that can deliver output growth in a challenging environment. With oil prices a point of pain or profit for all upstream operators, names that can deliver on a volumetric growth story and take market share should outperform.

This strategy has played out to perfection thus far, with our positions in Anadarko Petroleum Corp (NYSE: APC), Concho Resources (NYSE: CXO) and EOG Resources (NYSE: EOG) up an average of 86.9 percent over the intervening months.

In light of this run-up and the risk of rising service costs, the Jan. 25 issue of Energy & Income Advisor suggested that readers consider taking a partial profit off the table, especially with hedge funds’ aggregate long positions in West Texas Intermediate futures reaching record levels and creating a significant liquidation risk.

Our Model Portfolios also contain four legacy upstream names that we held through the down-cycle: Noble Energy (NYSE: NBL), Occidental Petroleum Corp (NYSE: OXY), Eni (Milan: ENI, NYSE: E) and Total (Paris: FP, NYSE: TOT). Here are our latest thoughts on these positions.

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    Elliott and Roger on Jul. 27, 2017

  • Portfolios & Ratings

    • Model Portfolios

      Balanced portfolios of energy stocks for aggressive and conservative investors.

    • Coverage Universe

      Our take on more than 50 energy-related equities, from upstream to downstream and everything in between.

    • MLP Ratings

      Our assessment of every energy-related master limited partnership.

    • International Coverage Universe

      Roger Conrad’s coverage of more than 70 dividend-paying energy names.

    Experts

    • Roger S. Conrad

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor

    • Elliott H. Gue

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor

    • Peter Staas

      Managing Editor: Capitalist Times and Energy & Income Advisor