Our Outlook for Energy Stocks

By Jason Stevens | Morningstar 

Macroeconomic concerns trumped stock fundamentals again this quarter and will likely dominate markets throughout 2012. Despite persistently low gas prices, we see more potential for upside here than with oil. Given the prospects for increased energy price volatility, we favor companies with relatively steady cash flows, like pipelines and deep-water drillers, and upstream companies with large drilling inventories of low-cost production. Despite looming financial storm clouds on nearly every horizon, oil prices have remained persistently high and relatively stable during 2011. We're less sanguine that this will be the case in 2012. Currently strong emerging markets demand has OPEC producing flat out, and there's very little spare capacity in the system, supporting high prices. Geopolitical tensions have also helped support prices since the Arab Spring, most recently with renewed fears over possible Iranian retaliation over trade embargos. But with Europe apparently entering a major recession and China bracing for a potential hard landing, we fear that 2012 could be a rough ride for energy investors.

A European recession could pull several million barrels a day of demand off the market, relieving some pressure on supply growth and increasing pressure on crude oil prices. However, the European economy is less oil-intensive than the United States, and most of the fat in Europe's transport sector has already been excised; barring a massive recession or an outright depression, we don't think Europe will shed as much demand as it did in 2008.

The bigger bogey is China. Here we note that a so-called hard landing does not mean that growth stalls or declines but that merely the pace of growth drops down to a lower gear. Gross domestic product growth of 5% for China would still result in incremental crude oil demand growth but would diminish China's ravenous appetite and thereby relieve pressure on supplies. The larger risk here is that China's central planners fail to anticipate knock-on effects of a slowing economy, and a lack of financing or a surfeit of unrest results in sharply lower industrial demand. This could potentially result in the marginal buyer of oil stepping away from the table, driving prices sharply lower.

Most economists we read point to the U.S. as a sole outpost of light, however dim. We disagree. It seems challenging to us to accept current conventional wisdom that the U.S. can manage close-to-trend growth in the face of a eurozone recession and slowing economic activity in China. In our view, the U.S. has only narrowly averted another recession this year, and we note that at current levels of consumption and at $100 per barrel, oil costs the U.S. economy approximately 4.5% of GDP, a level at which the U.S. has historically gone into recession.

In short, we see multiple threats to oil prices going into 2012 and expect higher volatility next year as headlines compete with fundamentals.

We expect less downside risk to gas prices in 2012, as we continue to believe that at current prices a fair amount of production is uneconomical. We've argued for some time that we should reach an inflection point on gas drilling, and that point has thus far failed to materialize. However, held-by-production drilling has slowed or stopped, most 2008-era hedges have rolled off, companies have worked their way through the first round of drilling carries, and gas-directed rig counts are down a little more than 10% from last year. We've seen encouraging signs that Barnett and Haynesville shale dry gas production has hit a plateau, and conventional gas is in sharp decline. The key variable to gas supply now is associated gas, or gas produced by so-called liquids drilling. Associated gas is effectively free to producers, which make their money on oil and natural gas liquids, and has served as a significant source of low-cost supply, pressuring gas prices. To the extent that associated gas production can increase faster than drillers step away from marginal and uneconomical drilling, we'll see gas prices remain low.

Industry-Level InsightsIn markets like this, we favor more defensive stocks, such as pipelines and supermajors, but we also look for opportunities to build positions in quality exploration and production firms with large drilling inventories of low-cost production. We caution investors that despite generally attractive current valuations, most energy stocks are susceptible to oil and gas price declines, and volatility in 2012 could result in large swings in stock prices, though our long-term theses might remain intact.

As a group, energy stocks are trading below our fair value estimates, with the median price/fair value ratio for the sector at 0.81, up a bit from last quarter's reading. The value in energy is currently in large-cap stocks, which boast a median price/fair value ratio of 0.80. Mid-cap stocks are trading at a price/fair value ratio of 0.84, and small-cap stocks are trading at 0.89 times fair value.

Looking to energy subsectors, we see the greatest opportunity currently in E&Ps and service names, stocks that tend to be more responsive to commodity price changes. E&Ps have a median price/fair value ratio of 0.77, while drillers, with a median price/fair value ratio of 0.76, and service companies, at 0.72, are very attractive. Integrated and refining stocks are trading at 0.81 times our fair value estimates. Midstream stocks are closest to fully valued, at a price/fair value ratio of 0.98.

Energy Stocks for Your RadarSome of the deepest values in energy can be found among our U.S. E&Ps, where several of our favorite companies are trading near 50% of intrinsic value. This quarter we're again highlighting two such companies: Ultra Petroleum(UPL) and Whiting Petroleum(WLL). Both companies are low-cost leaders, and both have large drilling inventories that will support years of drill-bit growth. Ultra is a producer of natural gas, with an unassailable gas asset in Wyoming's Pinedale anticline and a significant position in the Marcellus shale. Whiting, in contrast, is an oil-heavy name primarily focused on developing its massive Bakken shale acreage position.

Among integrated names, we're suggesting investors consider BG Group(BRGYY), an integrated gas dynamo that U.S. investors frequently overlook. BG's integrated gas model is poised for growth from the global liquified natural gas trade, and BG's position in offshore Brazil will transform the company into a major oil producer. We're also highlighting Baker Hughes(BHI), one of the big three global oilfield services companies. We think Baker is worth much more than its current stock price, as a result of strong U.S. and Canadian performance and rebounding international margins. Lastly we're adding Energy Transfer Equity(ETE), a midstream master limited partnership poised to complete the acquisition of Southern Union(SUG) in early 2012.

Ultra Petroleum (UPL)
Star Rating: 5 Stars Fair Value Estimate: $64.00 Economic Moat: Narrow Fair Value Uncertainty: Medium Consider Buying: $44.80

Ultra's Pinedale and Marcellus assets represent one of the best one-two punches in the North American E&P market. The firm's sizable inventory and industry-leading cost structure should support a decade or more of profitable, double-digit growth, even in the face of continued low gas prices. A takeout offer from one of the majors or a larger independent could also help fast-track value realization. As a company, Ultra is both scalable enough and "bite-size" enough to attract a wide range of potential suitors. If acquired, Ultra's takeout price could exceed our fair value estimate on a stand-alone basis.

Whiting Petroleum (WLL)
Star Rating: 5 Stars Fair Value Estimate: $85.00 Economic Moat: Narrow Fair Value Uncertainty: High Consider Buying: $51.00

With its Sanish Field acreage probably out of runway by 2014, we're glad to see Whiting fast-track its North Ward Estes program and aggressively go after other Bakken/Three Forks prospects. In the Williston Basin, especially, Whiting should be able to take advantage of its geoscientific familiarity, network of land brokers and title attorneys, contracted rigs and hydraulic fracking crews, and existing infrastructure to help drive efficiencies as it moves forward with exploration and development of new fields. Intermittent periods of midstream tightness remain possible in this region in the short term, though longer term we expect this to become less of an issue. As the company proves out acreage and the industry releases additional data points on emerging plays like the Wolfcamp, Bone Springs, and Niobrara, we expect to gain more insight into their longer-term potential.

BG Group (BRGYY)
Star Rating: 5 Stars Fair Value Estimate: $156.00 Economic Moat: Narrow Fair Value Uncertainty: Medium Consider Buying: $109.20

Despite the recent sell-off in the shares, our opinion of BG Group is unchanged, and we see the current price weakness as a buying opportunity. We have always viewed BG favorably because of its unique business model and growth potential, and recent events have only bolstered our confidence in the firm's future. Most notably, BG doubled its estimated recoverable resources in Brazil to 6 billion barrels of oil equivalent. The company thinks it can recover these additional barrels without any material additions to capital, which implies a much greater value for its Brazilian assets than previously thought. It should also be able to achieve plateau production levels earlier than previously anticipated. Combining this with projects in Australia and the U.S., BG offers unparalleled growth for a firm its size.

Baker Hughes (BHI)
Star Rating: 5 Stars Fair Value Estimate: $100.00 Economic Moat: None Fair Value Uncertainty: Medium Consider Buying: $70.00

We believe Baker Hughes represents a very attractive opportunity to benefit from secular trends in the oil-services sector, a reboot in international growth starting in the second half of 2011, and ongoing improvements from its own internal reorganization. Baker Hughes should benefit from the trends toward drilling more complex onshore and offshore wells as well as oil and gas companies seeking to boost reservoir recovery rates. In addition, we think Baker Hughes will show significantly better results in the fourth quarter of 2011 as Canada continues to recover from a severe seasonal breakup, which hurt Baker Hughes' North American results more than its peers because it is the largest services company in the country. Finally, Baker Hughes' international profitability still remains well below peak levels, which is a gap that we think will close as the market tightens during the next few years.

Energy Transfer Equity (ETE)
Energy Transfer Equity Star Rating: 5 Stars Fair Value Estimate: $56.00 Economic Moat: Narrow Fair Value Uncertainty: Medium Consider Buying: $39.20

Energy Transfer Equity has gone through a pivotal year in 2011, with the entry into the natural gas liquids transportation and fractionation through the purchase of Louis Dreyfus' Texas NGL business, the acquisition of Southern Union--which we expect to close in early 2012--and the sale of its retail propane operations. These transactions will shift Energy Transfer's contract mix more strongly toward fee-based cash flows, provide access to new markets, particularly Florida, and allow the partnership to compete across the midstream value chain. Energy Transfer Equity will also realize outsized benefits from pursuing a drop-down strategy, selling Southern Union's acquired assets to Energy Transfer Partners, its controlled MLP subsidiary.

Data as of 12-13-11.

Jason Stevens has a position in the following securities mentioned above: WLL