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Oil & Gas Industry Outlook - November 2017

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Crude Oil

Things can change very quickly in the oil market.

Just a few months ago, or until September, the commodity had a very difficult year. In June, U.S. West Texas Intermediate (WTI) fell to nearly $42 a barrel - the lowest in ten months.

Since then, the contract has risen about 30%. In fact, WTI hit a more than two-year high of above $55 recently. Therefore, it is not surprising that the Dow Jones industrial average’s two energy giants –– Zacks Rank #1 (Strong Buy) ExxonMobil (XOM - Free Report) and Chevron (CVX - Free Report) –– returned +9% and +7%, respectively, since September –– significant rises considering their status as ‘traditionally defensive plays’. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

What's Fueling the Bullish Market Sentiment?

Unlike other short-lived rallies over the past three years, we believe the current higher oil prices are a result of improving fundamentals.

Talks of Oil Production Cut Deal Extension: One of the significant reasons why the U.S. oil benchmark is soaring, revolves around expectations that OPEC and other major producers will agree to expand their output-cut deal beyond March. The agreement, already renewed once, keeps 1.8 million barrels a day (or 2% of global supply) off the market in an attempt to clear a supply glut. While there are several question marks over the degree to which the cartel members are adhering to their quotas, there's no ignoring the fact that the cuts continue to narrow the market imbalances.

Sharp Inventory Drawdowns: Investors have pinned hopes of recovery over the recent U.S. Energy Department's inventory releases that show multiple weeks of strong inventory draws in the domestic crude stockpiles – pointing to a slowdown in shale output. The nation's oil stockpiles have shrunk in 24 of the last 30 weeks and are down almost 80 million barrels since April.

The Shift into "Backwardation": Recently, the front-month WTI contract have shifted into "backwardation" – a phenomenon when near-term oil futures trade at a premium to futures dated further out. Analysts consider this as a bullish signal with the so-called backwardated market helping flush out inventories by eliminating the incentive to put oil in storage.

Fall in Rig Count: According to Baker Hughes’ closely watched weekly report, the oil rig count has gone down for a ninth week in 12. This implies that U.S. energy firms are cutting down on their capital investment plans. Importantly, this is an indicator that U.S. shale producers are showing signs of slowing down.

Booming Exports: The United States has never exported more than 2 million barrels of crude oil per day. During the week through Oct 27, the nation exported 2.13 million barrels a day of light oil, way higher than 400,000 barrels shipped after the lifting of the four-decade long ban on oil exports at the end of 2015. This clearly reflects the substantial demand for U.S. oil.

Favorable Economic Data: Upbeat third-quarter U.S. GDP data helped push oil to recent highs. Further, the October payroll report showed that the domestic labor market bounced back from the effects of hurricanes. A positive read on orders for U.S. durable goods also point to a strengthening economy. Finally, strong earnings reports from corporate biggies, which has helped support high valuations, boosted sentiments. With American economy remaining on solid footing, the resultant demand growth bodes well for oil prices.

Pullbacks Possible but We Might Have Seen Bottom for 2017

While we do not rule out chances for short-term pullbacks on oversupply concerns and a stronger U.S. dollar, we remain extremely confident of a bull run in the near future.

An anticipated surge in demand next year is set to push global consumption above 100 million barrels per day threshold for the first time. However, supply from OPEC – which still accounts for roughly 40% of the world's crude – is expected to remain weak for at least part of 2018. Also, years of low price environment have forced operators to trim their capital expenditures considerably that means a relatively narrow pipeline of new projects.

To sum it up, though the triple-digit territory of 2014 looks improbable, we expect oil prices to continue to head higher. Also, we are confident that improving fundamentals have probably put a floor under crude prices for the time being.

Natural Gas

Spurred by its cost effectiveness and abundant supply in North America, natural gas – the least harmful fossil fuel compared to coal and oil – is set for a major transformation. The commodity’s long-term demand is expected to soar due to the transition toward a low carbon future and growing usage of natural gas in the Asia-Pacific region.

Remarkable Rise in U.S. Gas Production

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.

On the flip side, the glut has kept prices constrained with demand failing to match supply. As per Energy Information Administration (EIA), the U.S. energy watchdog, the country is expected to churn out an average of 73.6 billion cubic feet (Bcf) per day of dry natural gas in 2017 and 78.5 Bcf per day next year. This will outweigh the total forecasted consumption of 73.1 Bcf per day this year and 76.8 Bcf per day in 2018.       

Demand Growth Driven by China

Despite domestic supply glut, the fundamentals of natural gas continue to be favorable in the long run, considering the secular shift to the cleaner burning fuel for power generation globally and in the Asia-Pacific region in particular.

The EIA predicts global demand for the commodity to grow from 340 Bcf per day in 2015 to 485 Bcf per day by 2040. Countries in Asia and in the Middle East – led by China’s transition away from coal – will account for most of this increase.

And it will be the world’s largest gas producer U.S., which will step up to meet this soaring demand. With domestic prices struggling to break the $3 per million Btuthreshold, U.S. natural gas companies see a big opportunity in selling cheap U.S. production at higher prices to rest of the world. In fact, more than 50% of the domestic volume growth in the near future will be used for export in the form of liquefied natural gas (LNG). As per Paris-based International Energy Agency (IEA), the United States will vie with Australia and Qatar as the top LNG exporter by 2022.   

Big Oil Banking on Gas

Foreseeing a prominent role for natural gas down the line, most oil majors have overhauled their businesses and invested heavily in the commodity. While it already constitutes over 50% of Royal Dutch Shell’s (RDS.A - Free Report) production, smaller European rival BP plc (BP - Free Report) , expecting lower-for-longer oil prices, has pledged shift toward gas in its portfolio. The world’s largest publicly traded oil company ExxonMobil has also jumped into the bandwagon to export natural gas from the U.S. in the form of LNG. Even Chevron and France-based TOTAL (TOT - Free Report) are looking at natural gas as a growing segment of their energy portfolios. 

Export Boom to Prop Up Prices in the Longer Run

Overall, long-term fundamentals for the commodity continue to be bullish on the back of structural imbalances. While domestic natural gas production is expected to go up this year, the growing use of LNG, booming exports, replacing coal-fired power plants and higher demand from industrial projects will likely take care of the increased output. These secular headwinds will start to have a positive impact on natural gas sentiment with price eventually settling above $3.

Valuation Signals Upside Too

Going by the EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation and amortization) ratio, which is often used to value oil and gas stocks, given their significant debt levels and high depreciation and amortization expenses, the industry doesn’t look expensive at this point. In fact, irrespective of the valuation metric used, ‘Energy’ is one of the cheapest sectors to own even as the broader market looks expensive.

The industry currently has a trailing 12-month EV/EBITDA ratio of 6.6, which is lower than the median value of 7.2 over the past year.

Additionally, the reading compares favorably with the market at large, as the current EV/EBITDA for the S&P 500 is at 11.7 and the median level is 10.7. The industry’s favorable positioning compared to the overall market certainly signals more upside.

What the Zacks Industry Rank Indicates

Oil/Energy is one the 16 broad Zacks sectors within the Zacks Industry classification and are further sub-divided into 10 industries at the expanded (aka “X”) level. We rank 265 X industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. (Click here to know more: About Zacks Industry Rank)

We put our X industries (all 265 of them) into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Coming back to the oil/energy industry, it is sub-divided into the following industries at the X level: Oil and Gas - Integrated - United States, Oil and Gas - Drilling, Oil and Gas - Exploration and Production - United States, Oil and Gas - Production Pipeline - MLP, Oil and Gas - Field Services, Oil and Gas - Integrated - International, Oil and Gas - Production and Pipelines, Oil and Gas - Mechanical and Equipment, Oil and Gas - Integrated – Canadian, and Oil and Gas - Refining and Marketing. The level of sensitivity and exposure to commodity prices vary for each industry.

In terms of Zacks Industry Rank, five of these 10 groups belong to the top 50% of the 250 plus Zacks industries and the other five are in the bottom 50%. Our back-testing shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The Zacks Industry Rank is #15 for Oil and Gas - Integrated - United States, #35 for Oil and Gas - Integrated - International, #39 for Oil and Gas - Integrated – Canadian, #39 for Oil and Gas - Refining and Marketing, #74 for Oil and Gas - Exploration and Production - United States, #202 for Oil and Gas - Drilling, #202 for Oil and Gas - Field Services, #206 for Oil and Gas - Production and Pipelines, #216 for Oil and Gas - Mechanical and Equipment and #224 for Oil and Gas - Production Pipeline - MLP.

Strong Q3 Earnings

A look back at the Q2 earnings season reflects that earnings for the sector recorded a massive 252.7% jump from the same period last year — by far the highest growth among all sectors — on 16.8% higher revenues.

The energy sector is poised to see the strongest growth in Q3 again. This is evident from the current upbeat projection of 153.1% year-over-year earnings growth for the sector. The top line is likely to witness an improvement of 20.1% from the year-ago levels.

True to the predictions, the sector came out quite a winner. So far, for the sector components enlisted on the S&P 500 index, total Q3 earnings grew 127.2% on 18.7% higher revenues.

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

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