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Industry Outlook

OUTLOOK

Crude Oil


The ongoing Syrian conflict -- particularly whether or not the U.S. will intervene -- a tightening global supply picture in view of the output loss from disruptions in Libya, together with positive momentum in the domestic manufacturing sector and bullish data from the Chinese economy have strengthened oil prices to 2-year highs of around $110 per barrel. Partly offsetting this favorable view has been a spike in U.S. production -- now at their highest levels since 1989 -- and suggestions that the U.S. may taper its monetary stimulus later this year.

The immediate outlook for oil, however, remains positive given the commodity’s constrained supply picture. In particular, while the Western economies exhibit sluggish growth prospects, global oil consumption is expected to get a boost from sustained strength in China, the Middle East, Central and South America that continue to expand at a healthy rate.

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 barrels 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 1.1 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 0.8 million barrels per day this year and by 1.2 million barrels per day in 2014.

In our view, crude prices in the final few months of 2013 are likely to exhibit a sideways-to-bearish trend, trading in the $100-$105 per barrel range. As tension over the U.S. military intervention over Syria show signs of settling down, we are likely to experience a pressure in the price of a barrel of oil.

Natural Gas

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 started to look up in 2013. 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 was gone, thereby driving commodity prices to around $4.40 per MMBtu in Apr -- the highest in 21 months.

During the last few weeks, though, natural gas demand has gone through a relatively lean period, as mild weather -- from July through mid-August -- prevailed over the country, leading to tepid electricity draws to run air conditioners. This led to a slide in the commodity’s price. In fact, healthy injections over last few weeks, plus strong production, have meant that supplies have overturned the deficit over the five-year average.

With more moderate weather expected during the next few weeks, leading to reduced power demand, natural gas prices may experience another downward curve. This, in turn, is expected to pull down natural gas producers, particularly small ones.

ZACKS INDUSTRY RANK

Oil/Energy is one the 16 broad Zacks sectors within the Zacks Industry classification. We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #88 and lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative.

The oil/energy industry is further sub-divided into the following industries at the expanded level: Oil – U.S. Integrated, Oil and Gas Drilling, Oil – U.S. Exploration and Production, Oil/Gas Production Pipeline MLP, ‘Oilfield Services, Oil – International Integrated, Oil – Production/Pipeline, Oilfield Machineries and Equipment, Oil – Integrated, and Oil Refining and Marketing.

The ‘Oil – U.S. Integrated’ is the best placed among them with its Zacks Industry Rank #36, comfortably placing it into the top 1/3rd of the 260+ industry groups, where it is joined by the 'Oil – U.S. Exploration and Production' with a Zacks Industry Rank #84.

The ‘Oil and Gas Drilling’ – with a Zacks Industry Rank #99 – just moves out of the top 1/3rd and into the middle 1/3rd. The ‘Oil – International Integrated’ also lies in the middle 1/3rd with Zacks Industry Rank #119. The ‘Oil/Gas Production Pipeline MLP’ and ‘Oilfield Services’ barely makes into the middle 1/3rd with a Zacks Industry Rank #161 and #166, respectively.

However, all the other sub-sectors -- Oilfield Machineries and Equipment, Oil - Production/Pipeline, Oil - Integrated, and Oil Refining and Marketing -- are featuring in the bottom one-third of all Zacks industries with respective Zacks Industry Ranks of #202, #202, #233 and #251, respectively.

Looking at the exact location of these industries, one could say that the general outlook for the oil/energy space as a whole is neutral-to-negative.

EARNINGS TRENDS

As far as overall results of the Oil/Energy sector is concerned, it displays a bearish trend with earnings falling 12.7% in the second quarter of 2013, weakening sharply from the 1.0% drop witnessed in the previous quarter. However, there was a marginal improvement in revenue performance, which was down 5.6% in the June quarter as against a decline of 6.3% in the first quarter.

Second quarter earnings across all 16 sectors covered by Zacks increased 2.5%, most of it coming from the Finance sector. Should we exclude Finance, earnings would be down 2.9% year over year, with one of the underperformers being the Oil/Energy sector.

In particular, the Oil/Energy sector has suffered from weak results from Exxon Mobil Corp. (XOM - Analyst Report), which has a significant weight within the sector. Nevertheless, the sector had a decent performance in terms of beat ratios (percentage of companies coming out with positive surprises). The earnings "beat ratio" was 54.8%, while the revenue "beat ratio" was 69.0%.

For more information about earnings for this sector and others, please read our 'Earnings Trends' report.

OPPORTUNITIES

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.

While all crude-focused stocks stand to benefit from rising commodity prices, companies in the exploration and production (E&P) sector are the best placed, as they will be able to extract more value for their products. In particular, we suggest exposure to small-cap, undervalued E&P players like Matador Resources Co. (MTDR - Snapshot Report) and Memorial Production Partners L.P. (MEMP - Snapshot Report), which enjoy the benefits of crude oil price leverage.

The current oil price environment should also benefit producers, particularly those international players having attractive growth opportunities in their home markets. One such standout name is PetroChina Company Ltd. (PTR - Analyst Report), which remains well-placed to benefit from the country’s growing appetite for energy and the turnaround in commodity prices. We are also encouraged by the natural gas price reform that is expected to boost PetroChina’s margins.

One may also capitalize on this opportunity with the related business sector of energy equipment service providers. Our top pick in this space is Dril-Quip Inc. (DRQ). This offshore drilling equipment maker boasts of highly engineered drilling and production equipment for deepwater severe-service applications and harsh environmental conditions.

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 buying Range Resources Corp. (RRC - Analyst Report) and Cabot Oil & Gas Corp. (COG - Analyst Report). Both of them have been among the better performing S&P stocks since the start of 2013, gaining 25% and 55% 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.

WEAKNESSES

We are bearish on Europe’s largest oil company Royal Dutch Shell plc (RDS.A - Analyst Report). The integrated player is particularly susceptible to its high exposure to the downstream business, as well as its major natural gas focus and lofty capital spending.

We are bearish on Brazil's state-run energy giant Petroleo Brasileiro S.A. (PBR - Analyst Report), or Petrobras S.A. Following the company’s lower-than-expected second quarter showing, we see little reason for investors to own the stock. The Rio de Janeiro-headquartered group remains plagued by several issues that include decreased liquids realizations, weak production, huge investment requirements and the possibility of heightened state interference.

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.

One sector that has underperformed the rest of the energy industry is ‘refining and marketing. With refiners being buyers of crude -- whose price has seen a steep climb recently -- their profitability has been negatively impacted due to a rise in the input cost and lower crack spreads. Against this backdrop, we are particularly bearish on Marathon Petroleum Corp. (MPC - Analyst Report).

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