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The improving economic scene, both here in the U.S. as well as worldwide, had been the main driver of the oil rally that saw the commodity zoom past the $90 per barrel level earlier this year.
However, apprehensions about high U.S. crude stocks and worries that China might tighten monetary policy to fight an overheating economy, have been weighing on investor sentiments, weakening oil prices to near $88 a barrel. Another headwind for the commodity has been high levels of product inventories (gasoline and distillate stocks remain above the upper boundary of the average range for this time of year).
But far too many factors weigh on oil prices –- from OPEC decisions and geostrategic tensions to the value of the U.S. dollar and seasonal variables –- to definitively size up each one of them for their respective impact on prices.
As per the latest release by the Energy Information Administration (EIA), crude supplies are above the year-earlier level and are over the upper limit of the average for this time of the year. Additionally, we remain concerned in light of the high gasoline and distillate inventory builds, both of which remain above their five-year averages.
This has led to demand concerns against a backdrop of high oil prices and persistently slow job growth. As such, crude oil’s near-term fundamentals remain weak, to say the least.
However, global oil demand is expected to grow at a healthy rate this year, buoyed by the continued economic recovery.
According to the EIA, world crude consumption grew by an estimated 2.2 million barrels per day in 2010, to 86.6 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 added that average global consumption growth over the next 2 years is likely to return to rates seen before the onset of the global downturn in 2008. EIA, in its Short-Term Energy Outlook, said that it expects the current economic recovery to contribute towards global oil demand growth of 1.4 million barrels per day in 2011 and 1.6 million barrels per day in 2012.
Recently, the Paris-based International Energy Agency (IEA), the energy-monitoring body of 28 industrialized countries, also raised its 2010 and 2011 world oil demand outlook, citing the impact of buoyant global economic growth and frigid weather conditions in the northern hemisphere. IEA predicts that global oil demand would increase by 1.6% (or 1.4 million barrels per day) annually, reaching 89.1 million barrels a day in 2011 from last year’s 87.7 million barrels a day. The energy agency’s current estimates for 2010 and 2011 are higher by 320,000 barrels a day from its last report, issued in December 2010.
The third major energy consultative organization, the Organization of the Petroleum Exporting Countries (OPEC), an intergovernmental organization that supplies around 40% of the world's crude, also forecasted stronger-than-previously-anticipated global oil demand in 2011. In its latest monthly oil report, OPEC said it expects world oil demand to grow by 1.2 million barrels per day in 2011, reflecting an increase of 400,000 barrels a day over the 2010 level and an upward revision of 200,000 barrels a day over the previous assessment.
We expect crude oil to trade in the $90 – $100 per barrel range in the near future, supported by the continued tightening of world oil markets. But this does not mean that we will not see any short-term pullbacks. On the whole, we expect oil prices in 2011 to be higher than 2010 levels, but remain significantly below 2008 peak levels.
Though the favorable weather this winter has brought down a hefty surplus over last year’s inventory level and the five-year average, the specter of a continued glut in domestic gas supplies still exists, with storage levels remaining above their five-year average.
A supply glut has 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%.
Looking forward, EIA expects average total production to dip slightly (by 0.3%) in 2011, due to a falling drilling rig count in response to lower prices, while total natural gas consumption is anticipated to decline by 0.9%, partly because of fewer heating degree-days during the winter months this year compared with 2010.
However, the commodity is expected to reverse this trend in 2012, growing at 1.6% year-over-year to 66.5 billion cubic feet per day, driven by healthy demand from the electric power and industrial sectors.
We believe this supply/demand dynamics -– the projected decline in production in 2011 and increase in natural gas consumption in 2012 –- will lead to the strengthening of natural gas prices late in this year and next.
But until then the weak fundamentals are going to continue to weigh on natural gas prices in the near-to-medium term, translating into limited upside for natural gas-weighted companies and related support plays.
In this current turbulent market environment, we advocate the relatively low-risk energy 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 Royal Dutch Shell plc ( RDS.A - Analyst Report ) .
Royal Dutch Shell’s recent quarterly outperformance has been driven by higher energy prices, operational and production efficiency, and contributions from its growth programs. The company has been able to boost returns and remain competitive in this difficult environment by embarking on aggressive cost reduction initiatives, exiting unprofitable markets and streamlining the organization.
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 China’s PetroChina Company Limited ( PTR - Analyst Report ) , which remains well-placed to benefit from the country’s growing appetite for energy and the turnaround in commodity prices. Being one of two Chinese integrated oil companies, PetroChina is well-positioned to capitalize on these favorable trends.
We are also positive on South African petrochemicals group Sasol Ltd. ( SSL - Analyst Report ) . Sasol’s highly-developed technical expertise in producing synthetic fuels in commercial quantities from low-grade coal and natural gas gives it a competitive edge over other industry players. A robust balance sheet and strong cash position are other positives in the Sasol story.
In recent times, Sasol has continuously focused on the commercialization of its gas-to-liquids (GTL) technology to capitalize on the opportunity to leverage the arbitrage between gas and oil prices. Under normal circumstances, the ratio of the price of oil (measured in $ per barrel) to the price of natural gas (in $ per million British thermal units) fluctuates between 6 and 12.
However, in recent times, this has decoupled to an unprecedented degree, up at around 20. With gas prices remaining at depressed levels and thereby diverging significantly from oil prices, Sasol is looking to utilize the spread by using its GTL technology.
Within the oilfield services group, we like Core Laboratories N.V. ( CLB - Analyst Report ) . 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.
Halliburton Co. ( HAL - Analyst Report ) , the world's second-largest oil services firm after Schlumberger Ltd. ( SLB - Analyst Report ) , is also a top pick. We like Halliburton’s leading position in the global oilfield services market, its broad and technologically-complex product and service offerings, and its robust financial profile. The company’s recent results have been driven by strong demand for its services in North America and improvement in activity in a number of international markets including Norway, West Africa, Iraq and Algeria.
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 Tesoro Corp ( TSO - Analyst Report ) . We expect income from Tesoro’s refining operations to improve. Additionally, we believe Tesoro’s strategic actions –- to improve its performance and competitiveness in a cost-effective manner –- will drive the company’s profitable growth and boost its stock valuation.
In the near term, the company stands to benefit from exposure to the premium margin West Coast region. Additional positives for Tesoro include the scale and diversification benefits afforded by its portfolio of seven refineries.
Engineering and construction firm McDermott International ( MDR - Analyst Report ) remains another of our favorites. Given its geographic footprint in high-growth regions, technology leadership and efficient execution skills, the company is poised to benefit from the strong industry fundamentals for offshore construction activities through 2010 and beyond.
We believe order flow and backlog for McDermott’s products and services will continue to be healthy and trend higher in the near-to-medium term. Continued success on big awards, growing international operations and a solid balance sheet add to the bullish sentiment.
We are bearish on natural gas producer Range Resources Corp. ( RRC - Analyst Report ) . Since natural gas accounts for approximately 80% of the company’s reserves and production, Range Resources’ results are particularly vulnerable to fluctuations in natural gas markets. As such, the company’s exposure to the current unfavorable macro backdrop (weak natural gas prices), remains a key area of concern, in our view.
Nexen Inc. ( ) , Canada's sixth largest independent oil and gas producer, is another company we would like to avoid for the time being. Though Nexen has a diversified exploration profile, its Gulf of Mexico exploration momentum was affected by the drilling moratorium in the region (which has since been lifted) following the Macondo incident.
Especially, Nexen’s shorter-term production outlook in the Gulf presents a lackluster picture, as the company expects volumes in the region to be flat (or slightly down) in 2011 due to natural declines. Meanwhile, stricter regulations on drilling and increased regulatory involvement following oil spill, is expected to lead to higher expenses for Nexen.
Lastly, we continue to be skeptical on offshore drillers, given the fallout from the Macondo incident and the high number of rigs available to the market. We take a pessimistic stance on Transocean Inc. ( RIG - Analyst Report ) and Noble Corp. ( NE - Analyst Report ) .
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