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Industry Outlook

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OUTLOOK

Crude Oil


Expectations of an improving economy and bullish supply data have strengthened oil prices to around $100 per barrel. Crude’s recent run has been spurred by the Federal Reserve’s measured Taper announcement. The central bank -- asserting that the U.S. economy was strong enough -- stated that it will reduce bond repurchases by $10 billion, bringing its monetary stimulus to $75 billion a month from Jan 2014.

This has fueled hopes for robust fuel and energy demand in the world's biggest oil consumer. The bullish momentum was further propelled by positive revision to third quarter GDP numbers and continued decline in U.S. supplies.

Partly offsetting this favorable view has been a spike in domestic production -- now at their highest levels since 1988 -- and suggestions of increase in Libyan oil exports following months of political turmoil.  

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 1.1 million barrels per day in 2013 to a record-high level of 90.3 million barrels per day.

The agency, in its most recent Short-Term Energy Outlook, said that it expects global oil demand growth by another 1.2 million barrels per day in 2014. Importantly, EIA’s latest report assumes that world supply is also likely to go up by 1.2 million barrels per day in 2014.

In our view, crude prices in the first half of 2014 are likely to exhibit a sideways-to-bearish trend, trading in the $90-$100 per barrel range. As North American supply remains strong and the groundbreaking agreement with Iran makes it easier for the country to sell the commodity, 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).

Investors continue to focus on temperature patterns to understand the fuel’s economic dynamics. As it is, natural gas fundamentals look uninspiring with supplies remaining ample in the face of underwhelming demand. In fact, it is expected to take many years for the commodity’s demand to match supply in the face of newer projects.

Despite these issues, natural gas rallied to a two-year high recently on the back of persistent decreases in natural gas supplies and forecasts of freezing cold weather conditions, which boost natural gas demand for space heating by residential/commercial consumers.

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–C$ Integrated, and Oil Refining and Marketing.

The ‘Oil and Gas Drilling’ is the best placed among them with its Zacks Industry Rank #29, comfortably placing it into the top 1/3rd of the 260+ industry groups, where it is joined by the Oil Refining and Marketing ' with a Zacks Industry Rank #74.

The ‘Oil/Gas Production Pipeline MLP’ -- with a Zacks Industry Rank #96 -- moves out of the top 1/3rd and into the middle 1/3rd. The ‘Oil – U.S. Exploration and Production’ also lie in the middle 1/3rd, with Zacks Industry Rank #149.

However, all the other sub-sectors -- Oil - Production/Pipeline, Oil–C$ Integrated, Oilfield Services, Oil – International Integrated, Oil – U.S. Integrated, and Oilfield Machineries and Equipment -- are featuring in the bottom one-third of all Zacks industries with respective Zacks Industry Ranks of #181, #191, #206, #208, #214 and #237, 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 an encouraging trend. While earnings fell 8.4% in the third quarter of 2013, it improved from the 11.2% drop witnessed in the previous quarter. What’s more, there was a marked enhancement in revenue performance, which was up 2.8% in the September quarter as against a decline of 5.4% in the second quarter.

The sector had a mixed performance in terms of beat ratios (percentage of companies coming out with positive surprises). The earnings "beat ratio" was an impressive 62.2%, but the revenue "beat ratio" was underwhelming, at 37.8%.

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). 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 Harvest Natural Resources Inc. (HNR - Snapshot Report) and Abraxas Petroleum Corp. (AXAS), which enjoy the benefits of crude oil price leverage.

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.

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 quarters. The company’s inexpensive valuation and a favorable DOJ verdict over its role in the Macondo oil spill lend additional support.

Within the contract drilling group, we like Helmerich & Payne Inc. (HP - Analyst Report). Supported by a superior and diversified drilling fleet, together with a healthy financial profile, we expect the company to sustain its profitability over the foreseeable future. We believe Helmerich’s technologically-advanced FlexRigs will continue to benefit from an upswing in U.S. land drilling activity and the shift to complex onshore plays that require highly intensive solutions.

Offshore drilling giant Transocean Ltd. (RIG - Analyst Report) is also a top pick. With its technologically-advanced and versatile offshore drilling fleet, strong backlog and considerable pricing power, the company offers an unmatched level of earnings and cash flow visibility. The recent dividend approval and the settlement of a host of civil/criminal claims associated with the Deepwater Horizon incident have also eased the overhang on the stock.

Finally, buoyed by the favorable trends in the refining sector, we are more optimistic on the industry than we were a few months ago. After going through a bumpy ride for much of 2013, the sector has started to look up -- and it’s mainly to do with the ‘oil spread,’ the difference between the WTI price and its global counterpart, Brent.

With refiners being buyers of WTI, while selling their products based on Brent, the wider the so-called ‘Brent-WTI spread,’ the better it is for the sector components. With current oil spread at more than $10 per barrel, refinery stocks are set to benefit. Against this backdrop, we are particularly bullish on Valero Energy Corp. (VLO - Analyst Report) and Western Refining Inc. (WNR - Analyst Report).

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 also skeptical 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.

We see little reason for investors to own domestic upstream operator Noble Energy Inc. (NBL - Analyst Report), particularly due to the flood in Northern Colorado, which is expected to negatively impact production in fourth quarter. In addition, Noble’s international business operations are exposed to political and economic risks rife in West Africa and the Middle East.

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.

Land drilling contractor Nabors Industries Ltd. (NBR - Analyst Report) is another company we would like to avoid for the time being, mainly due to headwinds in the pressure pumping market on the back of collapsing prices and lower utilization. The recent weakness in the North American onshore rig count has also been a negative. As usual, we remain concerned about weak natural gas fundamentals, which are likely to limit the company’s ability to generate positive earnings surprises. Nabors’ fairly debt-heavy balance sheet also remains an issue.

Lastly, we recommend avoiding contract drilling services provider Rowan Companies plc (RDC - Analyst Report). The volatility in the macro backdrop along with operational hindrances raises concerns. Furthermore, the company expects its contract drilling expenses to increase by 5% to 7% in 2013. Rowan also expects 2014 operating costs to rise by 10% to 11% from 2013 levels.

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