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Industry Outlook

OUTLOOK

Crude Oil


Positive economic data and geopolitical fears have helped oil prices stay above the major psychological threshold of $100 per barrel.

Crude’s recent run has been spurred by a spate of upbeat reports, providing further evidence that the U.S. economy is coming out of its winter freeze. This has prompted hopes for robust fuel and energy demand in the world’s biggest oil consumer. The bullish momentum has been further propelled by the continued standoff in Ukraine that could disrupt supply from oil-rich Russia.

Sentiments were also helped by the Federal Reserve’s measured Taper announcement. The central bank -- asserting that the U.S. economy was strong enough -- reduced bond repurchases to $65 billion a month from February.

Partly offsetting this favorable view has been a spike in domestic production -- now at their highest levels since 1988 – that has ballooned crude inventories to 397.7 million barrels, the most on record. The imminent resumption of oil exports from the Libyan coast has also been a drag on prices.  

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, which continue to expand at a healthy rate despite some moderation.

According to the Energy Information Administration (EIA), which provides official energy statistics from the U.S. Government, world crude consumption grew by an estimated 1.2 million barrels per day in 2013 to a record-high level of 90.4 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, the EIA’s latest report assumes that world supply is likely to go up by 1.4 million barrels per day in 2014.

In our view, crude prices in the next few months 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).

However, things have started to look up somewhat following a frigid winter that saw the heating fuels’ demand take off. This pushed commodity prices to its highest level in 5 years earlier this year. In fact, natural gas supplies are coming off their 11-year-lows, prompting fears about the timely replenishment of the inventories ahead of the next heating season, starting from November.

As such, natural gas’ near-term fundamentals remain sketchy, to say the least.

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 Refining and Marketing’ is the best placed among them with its Zacks Industry Rank #66, comfortably placing it into the top 1/3rd of the 259+ industry groups, where it is joined by the ‘Oil/Gas Production Pipeline MLP’ with a Zacks Industry Rank #82.

The ‘Oil – U.S. Exploration and Production’ -- with a Zacks Industry Rank #100 -- moves out of the top 1/3rd and into the middle 1/3rd. The ‘Oil–C$ Integrated,’ ‘Oil – U.S. Integrated,’ ‘Oilfield Services’ and ‘Oil and Gas Drilling’ also lie in the middle 1/3rd, with Zacks Industry Ranks of #101, #101, #148 and #164, respectively.

However, all the other sub-sectors -- Oil - Production/Pipeline, Oil – International Integrated, and Oilfield Machineries and Equipment -- are featuring in the bottom one-third of all Zacks industries with respective Zacks Industry Ranks of #179, #192 and #203.

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 mixed trend.

For the 32% industry components that have come out with their Q1 reports -- comprising 21.0% of the sector market capitalization -- earnings rose 13.7% during the March quarter, a substantial decline from the 22.8% increase witnessed in the previous quarter. However, there was some improvement on the revenue front, which was up 9.3% in the first quarter as against a gain of 8.8% in the fourth quarter.

The sector has also been erratic in terms of beat ratios (percentage of companies coming out with positive surprises). The earnings "beat ratio" was an impressive 71.4%, but the revenue "beat ratio" was underwhelming, at 42.9%.

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 its 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 Callon Petroleum Co. (CPE), Miller Energy Resources Inc. (MILL - 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 Cameron International Corp. (CAM). This oil drilling equipment maker boasts of a diversified product portfolio, specialty service capabilities and proprietary technological expertise. Other positives for Cameron include a strong backlog position, growing international operations and a favorable outlook for subsea activity levels.

Further, we remain optimistic on the near-term prospects of Baker Hughes Inc. (BHI). The oilfield services behemoth during its recent first quarter outperformance pointed towards an improving North American market, coupled with strength in the Middle East and Asia. Baker Hughes also remains positive about stepped-up activity in the U.S. Gulf of Mexico.

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 & Payne’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.

Canada's biggest energy firm and the largest oil sands outfit Suncor Energy Inc. (SU - Analyst Report) is also worth a look. We like the company’s impressive portfolio of growth opportunities, unique asset base and high return potential in the long run. Suncor has significant oil sands and conventional production platform, huge long-lived oil-sands reserves and a robust downstream portfolio. The company's asset base includes substantial conventional reserves and production at offshore Eastern Canada and in the North Sea, which generate strong margins and should provide free cash flow to fund future oil sands expansion.

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). It has been among the better performing S&P stocks since the start of 2014, gaining 12% during the period. Most of the gains have been driven by Range Resources’ exposure to the high-return Marcellus Shale play, as well as the company’s above-average production growth.

WEAKNESSES

Fears of an economic slowdown in China have prompted us to be bearish on the country’s main integrated energy players, PetroChina Company Ltd. (PTR - Analyst Report) and Sinopec (SNP - Analyst Report). Both remain exposed to the risk of China’s stuttering economic growth that may significantly decrease its demand for oil, natural gas and chemicals.

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 engineering and construction firm McDermott International Inc. (MDR - Analyst Report). Following McDermott’s recent stock offering and disappointing first quarter operational update, we have become bearish about the firm’s near-term prospects. The company’s steep operating costs, an erratic earnings trend over the last few quarters and lack of clarity about some of the big projects add to the negative sentiment.

Based upon the number of near-term challenges, we remain pessimistic on the near-term prospects of Talisman Energy Inc. (TLM - Analyst Report). In particular, we expect investor sentiment towards the Canadian energy explorer to remain lukewarm, considering its maintenance/production issues and operational problems. We further believe that Talisman’s policy shift towards the promising North American oil and liquids rich areas will take some time to bear results.

Contract drilling services provider Rowan Companies plc (RDC - Analyst Report) is another company we would like to avoid for the time being. 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 2014. Rowan also expects this year’s operating costs to rise by 10% to 11% from 2013 levels.

Lastly, we recommend avoiding legacy offshore driller like Transocean Ltd. (RIG - Analyst Report). The most pressing concern for the group, at least in the short-term, will be oversupply in the rig market. With multinational energy biggies looking to reign in their skyrocketing capital expenses, the offshore drilling space is likely to see intense competition, as multiple firms run after a single contract.

This excess capacity, in turn, could lead to lower utilization or dayrates. As the sector looks set to enter a cyclical downturn and struggle with idled rigs, we do not see an immediate rebound in the sentiment and expect more punishing times ahead for the likes of Transocean.

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