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Industry Outlook

OUTLOOK

Crude Oil


Mounting worries about Europe's debt crisis, a persistently weak U.S. jobs market and less-than-encouraging guidance from the Federal Reserve have been weighing on investor sentiment, weakening oil prices to around $85 a barrel.

Apprehensions about high U.S. crude stocks, the release of emergency oil supplies from government-held strategic reserves into the world market, and uncertainty over oil supply disruptions in the Middle East have added to the negative sentiment.

These issues have stoked fears about the demand outlook for oil that has seen the commodity’s price plummet to 12-month lows earlier in the month. Incidentally, crude prices zoomed past the $110 per barrel level during the first half of the year.

As per the latest release by the Energy Information Administration (EIA), which provides official energy statistics from the U.S. Government, crude supplies are still in the upper limit of the average for this time of the year. This has led to domestic demand concerns against a backdrop of continued weak job growth.

But while the Western economies exhibit sluggish growth prospects, global oil consumption is expected to get a boost from the sustained strength in the major emerging powers like India and China that continue to grow at a healthy rate.

As such, crude oil’s near-term fundamentals remain patchy, to say the least. The long-term outlook for oil, however, remains favorable given the commodity’s constrained supply picture.

According to the EIA, world crude consumption grew by more than 2 million barrels per day in 2010 to a record-high level of 87.1 million barrels per day, which more than made up for the losses of the previous 2 years and surpassed the 2007 level of 86.3 million barrels per day (reached prior to the economic downturn). One might note that global demand for 2009 was below the 2008 level, which itself was below the 2007 level -- the first time since the early 1980’s of two back-to-back negative growth years.

The agency, in its most recent Short-Term Energy Outlook, said that it expects global oil demand growth of 1.3 million barrels per day in 2011 and 1.4 million barrels per day in 2012. EIA’s latest demand growth forecast for 2011 is 50,000 barrels per day lower than in the earlier version, as the agency sees declining consumption in developed countries. But for 2012, EIA has raised its global oil demand forecast by the same amount, stressing on robustness in China and other emerging economies.

Recently, the Organization of the Petroleum Exporting Countries (OPEC) -- which supplies around 40% of the world's crude -- trimmed its 2011 and 2012 world oil demand growth outlooks, citing the unsteady global market and in particular the worsening economic outlook in the more developed countries. OPEC predicts that global oil demand would increase by 880,000 barrels per day annually, reaching 87.81 million barrels a day in 2011 from last year’s 86.93 million barrels a day.

OPEC’s current growth estimate for 2011 is lower by 180,000 barrels a day from its last report, issued in September 2011. In 2012, OPEC expects global oil demand to grow at a slightly higher 1.19 million barrels per day. This reflects a downward revision of 80,000 barrels per day from the previous month’s report.

The third major energy consultative body, the Paris-based International Energy Agency (IEA), the energy-monitoring body of 28 industrialized countries, also forecasted weaker-than-previously-anticipated global oil demand growth in 2011 and 2012. In its latest ‘Oil Market Report,’ IEA said it expects world oil demand to grow by 1.0 million barrels per day in 2011, reflecting a downward revision of 50,000 barrels a day over the previous assessment.

For 2012, the agency has curbed its estimate for world oil demand growth by 210,000 barrels per day and now sees consumption to grow by 1.3 million barrels per day. IEA has attributed the cuts in its oil demand growth outlook to downward adjustment to global GDP growth assumptions.

We expect crude oil to trade in the $85-$95 per barrel range in the near future, reflecting upward pressure due to supply uncertainty from the ongoing unrest in oil-producing regions and downward pressure because of lower economic growth expectations.

Natural Gas

A supply glut pressured natural gas futures for much of 2010, as production from dense rock formations (shale) -- through novel techniques of horizontal drilling and hydraulic fracturing -- remain robust, thereby overwhelming demand.

As per the U.S. Energy Department, domestic gas output increased significantly in 2010, by an estimated 2.4 billion cubic feet per day, or 4.1%, as production declines in Alaska and the Gulf of Mexico were offset by a healthy increase in lower-48 onshore volumes. Storage amounts hit a record high of 3.840 trillion cubic feet in November, while gas prices during the year fell 21%.

However, stocks of the commodity slid approximately 2.261 Tcf during the five-month period (November 5, 2010 to April 1, 2011) on the back of a colder-than-normal end to this past winter, production freeze-offs in January/February, and the steadily declining rig count.

These factors cut into the U.S. supply overhang, thereby creating a deficit in natural gas inventories after erasing the hefty surplus over last year’s inventory level and the five-year average level.

However, natural gas demand is currently going through a lean period with the end of the peak cooling loads for summer and ahead of the winter heating season, coupled with tepid industrial demand in a weak economy.

Looking ahead, EIA expects average total production to rise by 6.7% in 2011 and by 2.1% in 2012, while total natural gas consumption is anticipated to grow by 1.9% this year and by a marginal 0.7% during the next year.

We believe these supply/demand dynamics -- the projected lower production growth and almost flat consumption -- will lead to the strengthening of natural gas prices in 2012.

But until then the weak fundamentals are going to continue to weigh on natural gas prices, translating into limited upside for natural gas-weighted companies and related support plays.

OPPORTUNITIES


We are positive on Norway-based major international integrated oil and gas producer Statoil ASA (STO - Analyst Report). The company has operations in all major hydrocarbon-producing regions of the world, with an emphasis on the Norwegian Continental Shelf (NCS).

We believe that Statoil is well positioned to sustain its steady production growth for the next few years on the back of its large resource base at NCS. We also believe that the growing share of natural gas in the company’s NCS volume mix and its extensive interests in infrastructure assets enable it to play a leading role in the European natural gas market.

Within the oilfield services group, we like Core Laboratories N.V. (CLB). We are a fan of Core Labs’ leadership position in the reservoir optimization niche, along with its global footprint and deep portfolio of proprietary products and services. Furthermore, the company’s low asset intensive operations and limited capex needs allow it to generate substantial free cash flows.

Baker Hughes Inc. (BHI), the world’s third-largest oil services firm after Schlumberger Ltd. (SLB - Analyst Report) and Halliburton Co. (HAL - Analyst Report), is also a top pick. We like Baker Hughes’ leading position in the global oilfield services market, along with its broad and technologically-complex product and service offerings.

We believe Baker Hughes is well positioned to gain from two positive aspects having positive influences on the global oil service business. The first is a structural shift in North America mainly benefiting from the integration of BJ Services business, and the other is an international turnaround that is in its early stages.

Among the oil drilling equipment makers, we are particularly bullish on FMC Technologies Inc. (FTI - Analyst Report) and Cameron International Corp. (CAM). We believe both the companies are well positioned going forward given their dominant market share, technology leadership, efficient execution skills and strong backlog position.

The increase in North American drilling activity, along with potential opportunities from the industry complying with new pressure control equipment rules, has added to this bullish sentiment. Furthermore, we believe that FMC Technologies and Cameron are poised to benefit from the improving subsea activity levels through 2011.

Onshore contract driller Patterson-UTI Energy Inc. (PTEN - Analyst Report) is also worth a look, reflecting strong demand for its services in North America. The company has been benefiting from increased activity in the unconventional oil and liquids-rich plays in the region, which have more than made up for the soft natural gas fundamentals.

We believe Patterson-UTI’s earnings will continue to push higher, benefiting from its growing premium land rig fleet and the current boom in pressure pumping services. Additionally, the company’s stellar financial health (free cash flow positive and a debt-free balance sheet) stands it in good stead.

Buoyed by the favorable trends in the refining sector, we are more optimistic on the industry than we were 12 months ago. Uptick in economic activity overseas (mainly in China and India) and prospects for higher fuel demand in the U.S. are likely to push 2011 industry margins higher than last year’s levels. Against this backdrop, we are particularly bullish on Valero Energy Corp (VLO), Tesoro Corp (TSO - Analyst Report) and Western Refining Inc. (WNR - Analyst Report).

WEAKNESSES

The current turbulent market environment -- characterized by the decline in short-term demand assumptions on the back of recession fears in the U.S. and EU and high uncertainty -- have taken its toll on the energy conglomerate business structures of the large-cap integrateds. As a result, we are bearish on Eni SpA (E - Analyst Report), Royal Dutch Shell plc (RDS.A - Analyst Report) and TOTAL SA (TOT - Analyst Report). The dip in oil prices to around $80 per barrel is likely to further limit their ability to generate positive earnings surprises.

Onshore contract driller Helmerich & Payne (HP - Analyst Report) is another company we would like to avoid for the time being, mainly due to the weak natural gas fundamentals. Helmerich & Payne, which specializes in shallow to deep drilling in gas producing basins of the U.S., remains particularly exposed to this situation.

We are also skeptical on Canadian independent oil and gas producers like Nexen Inc. (NXY) and Canadian Natural Resources Ltd. (CNQ). In particular, the recent steep drop in crude oil prices may render the oil sands mining initiatives as economically unviable considering the high up-front costs required for their development. In this case, companies may have to call off or postpone projects under construction.

Lastly, we expect shares of independent gas-focused exploration and production firms such as Devon Energy Corp. (DVN), Forest Oil Corp. (FST - Analyst Report), Cabot Oil and Gas (COG), etc. to be under pressure in the near future.

These companies’ high natural gas exposure raises their sensitivity to gas price fluctuations, compared to the more-diversified independent peers with a balanced oil/gas production profile. Continued low natural gas prices have created a difficult operating environment for the firms.

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