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Record-high U.S. crude stocks, a struggling European economy, worries about China’s growth outlook, and the strong dollar have weakened oil prices to around mid-$90s a barrel. Partly offsetting this unfavorable view has been the improvement in domestic labor market conditions that points towards an improving economic growth backdrop.
The immediate outlook for oil, however, remains tepid given the commodity’s fairly positive supply picture. In particular, while Saudi Arabia is likely to cut back on its production, global oil output is expected to get a boost from sustained strength in North America, Iraq, Angola, Brazil and Colombia. On the other hand, the growth in global liquids fuel demand will be relatively soft in the absence of a strong global recovery.
According to the Energy Information Administration (EIA), which provides official energy statistics from the U.S. Government, world crude consumption grew by an estimated 0.7 million barrel per day in 2012 to a record-high level of 89.0 million barrels per day.
The agency, in its most recent Short-Term Energy Outlook, said that it expects global oil demand growth by another 0.9 million barrels per day in 2013 and by a further 1.2 million barrels per day in 2014. Importantly, EIA’s latest report assumes that world supply is likely to go up by 0.6 million barrels per day this year and by 1.8 million barrels per day in 2014.
In our view, crude oil prices in the second half of 2013 are likely to exhibit a sideways-to-bearish trend. With domestic demand relatively soft and the global economy still showing signs of weakness, the fact that supply will be outpacing consumption appears to be evident.
As long as sharp crude output growth from North America continues and the world demand is unable to keep up with that, we are likely to experience a pressure in the price of a barrel of oil. We assume that crude will trade in the $90-$95 per barrel range for the near future.
Over the last few years, a quiet revolution has been reshaping the energy business in the U.S. The success of ‘shale gas’ -- natural gas trapped within dense sedimentary rock formations or shale formations -- 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, natural gas inventories in underground storage hit an all-time high of 3.929 trillion cubic feet (Tcf) in 2012. The oversupply of natural gas pushed down prices to a 10-year low of $1.82 per million Btu (MMBtu) during late April 2012 (referring to spot prices at the Henry Hub, the benchmark supply point in Louisiana).
However, things have started to look up in recent times. This year, cold winter weather across most parts of the country boosted natural gas demand for space heating by residential/commercial consumers. This, coupled with flat production volumes, meant that the inventory overhang has now gone, thereby driving commodity prices to $4.38 per MMBtu – the highest since Sep 2011.
This, in turn, is expected to buoy natural gas producers. With the financial incentive to produce the commodity and the subsequent improvement in the companies’ ability to generate positive earnings surprises, the stocks are likely to move higher.
But as the weather continues to turn milder and temperatures reach higher-than-normal levels, natural gas demand may suffer in the near future on account of above-average builds, thereby pulling down prices again.
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 - Analyst Report). 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 domestic exploration and production (E&P) group, we like SM Energy Co. (SM - Analyst Report) and EPL Oil & Gas Inc. (EPL). Supported by attractive oil and gas investments, balanced and diverse portfolio of proved reserves, together with development drilling opportunities, we expect the companies to sustain their production growth and profitability over the foreseeable future.
Further, we remain optimistic on the near-term prospects of Halliburton Co. (HAL - Analyst Report). The oilfield services behemoth -- among the top three players in each of its product/service categories -- is enjoying strong demand for its services in international markets and expects the trend to continue in the coming years. Additionally, the company remains in excellent financial health and has recently announced a 39% increase in its quarterly dividend.
China's CNOOC Ltd. (CEO - Analyst Report) is also a top pick. CNOOC remains well-placed to benefit from the country's growing appetite for energy and the turnaround in commodity prices. In particular, the company enjoys a monopoly on exploration activities in China 's very prospective offshore region in addition to having a growing presence in the country's natural gas and liquefied natural gas (LNG) infrastructure. The recent acquisition of Canadian energy producer Nexen Inc. will further improve CNOOC’s growth profile by augmenting proven reserves by 30%, while helping it to vastly expand its holdings in Canada.
Finally, despite the uncertain natural gas fundamentals and the understandable reluctance on the investors’ part to dip their feet into these stocks, we would advocate to opt for Canada ’s biggest natural gas producer Encana Corp. (ECA - Analyst Report). Encana has one of the largest natural gas resource portfolios in North America, which provides a diverse/high quality inventory of reserves. We see a solid long-term future for the company as demand for natural gas soars, spurred by its cost effectiveness and abundant supply in North America.
We are bearish on Italian energy company Eni SpA (E - Analyst Report). The integrated player -- with a large presence in Libya -- has seen its total production fluctuate in recent times, primarily due to operational disturbances at several fields in the North African nation.
Additionally, Eni's upstream portfolio carries greater political risk than its peers, since it has the highest exposure to the OPEC countries. The Rome-based company has also been mitigated by a weak macroeconomic scenario in Italy and Europe that is likely to affect its performances going forward.
Based upon the number of near-term challenges, we remain pessimistic on the near-term prospects of National Oilwell Varco Inc. (NOV - Analyst Report). With markets remaining competitive and pricing likely to be soft, the energy equipment maker’s margins are expected to suffer in the next few quarters. Recent weakness in the North American onshore drilling environment has also been a negative. Furthermore, we expect shares to remain depressed until it increases its sub-par dividend yield.
Energy-focused engineering and construction firm McDermott International Inc. (MDR - Analyst Report) is another company we would like to avoid for the time being, mainly due to its erratic earnings trend over the last few quarters and a disappointing outlook for 2013. Apart from having to deal with steeper operating costs, McDermott has already hinted that its top line will suffer next year due to uncertainty regarding the timing of big awards.
Near-term bookings also remain lumpy, as the current uncertain environment has hurt the economics of building new oil and gas infrastructure. Additionally, the transfer of the power generation and government operations has left McDermott with a less diversified business, thereby heightening its risk profile.
We are also skeptical on independent energy exploration firms Cabot Oil and Gas Corp. (COG - Analyst Report) and Range Resources Corp. (RRC). Both of them have been among the better performing S&P stocks since the start of 2013, gaining 40% and 20% during the period, respectively. Most of the gains have been driven by their exposure to the high-return Marcellus Shale play, as well as their above-average production growth.
But given natural gas’ volatile fundamentals and the duo’s high exposure to the commodity, we do not believe that the stocks will be able to sustain the momentum in the near future. The companies’ steep valuations as well as miniscule payouts also worry us.