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Expect a Bumpy Ride in These Energy Stocks

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The oil market, notwithstanding its recent rise, could be undermined by soaring U.S. production. Volume from U.S. oil fields (inclusive of shale) has risen 22% since mid-2016 to 10.3 million barrels per day – the most since the EIA started maintaining weekly data in 1983. In early February, oil production broke through the 10 million barrels a day threshold for the first time in nearly 50 years and has maintained the record levels thereafter.

While there is renewed optimism among U.S. oil companies amid the $60-plus WTI prices, crude’s recent gains could become self-defeating as elevated realizations have already induced producers – especially U.S. shale drillers – to ramp up activity. Together with the scheduled conclusion of OPEC/non-OPEC production cuts in December this year and we are looking at another selloff in oil prices.

A rise in the oil drilling rig count points to a further increase in domestic output. An early gauge of future activity, rigs drilling for oil in America totaled 800 in the week to Mar 2, as per the latest weekly report by Baker Hughes, a GE Company. That's much higher than the year-ago tally of 609, indicating a drilling resurgence in tandem with the oil revival – a big concern for investors.

Meanwhile, natural gas continues to struggle as well, with production forecasted to rise to an all-time high of 81.70 billion cubic feet per day (Bcf/d) in 2018. That would easily top this year’s demand projection of 78.19 Bcf/d.

Despite an extended stretch of record low temperatures in the U.S. from late December into January, the heating fuel could not move meaningfully higher. Things took a turn for the worse with the February weather turning out to be disappointing amid sustained strong output. Now, with the 2017-2018 winter heating season on its last leg, natural gas prices over the coming weeks are unlikely to go above $3 per million Btu.

Overall, the tough market conditions for oil and gas have prompted money managers to raise red flags for certain types of energy stocks.

MLPs Don’t Sit Well with Investors

Master limited partnerships (or MLPs) are essentially infrastructure holdings of energy companies that feed off the broader sector. But these midstream operators are not direct oil and gas plays as they derive a major portion of their revenues from fee-based contracts depending on volume and are largely insensitive to commodity price fluctuations.

But so far, this year, it's not been smooth sailing for them. We note that the benchmark Alerian MLP Index (AMLP - Free Report) has logged a return of -6% year to date. Apart from sliding oil and gas prices, the crash has been triggered by a host of downward guidance revisions and tepid distribution outlook.

Of late, capital market access has remained tough and credit metrics stretched, making it difficult for the oil and gas transporters to execute on their growth projects. As a result, the distribution outlook became uncertain with a number of MLPs left with no choice but to defer their payout increases or in certain cases, even trim them. And with most investors owning MLPs for the benefit of generous, periodical distributions, many have understandably abandoned the sector.

A recent case in point is NuStar Energy L.P. (NS - Free Report) , which lost more than 20% after announcing plans to reduce its quarterly distribution as part of a merger decision with its general partner. Meanwhile certain partnerships such as Zacks Rank #4 (Sell) Plains All American Pipeline, L.P. (PAA - Free Report) and NGL Energy Partners L.P. (NGL - Free Report) have issued lackluster forward guidance amid volume and pricing pressures, indicating uncertain future cash flows.

(You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.)

We expect the commodity price-associated volatility for the MLPs to persist for some time and advise investors to steer clear of this asset class. In particular, bottom-rankers including Archrock Partners L.P. APLP, Antero Midstream Partners L.P. AM and Boardwalk Pipeline Partners L.P. (BWP - Free Report) are risky bets that are best avoided at the moment.

Dim Outlook for Drillers Still Battling Harsh Operating Conditions

With crude prices oscillating between $45 and $50 a barrel for most of 2017 – down 55% from mid-2014 levels – the top energy companies cut spending (particularly on the costly drilling projects) on the back of lower profit margins. This, in turn, meant less work for the beleaguered drillers as exploration for new oil and gas projects almost came to a standstill.

Moreover, with large, multinational energy firms looking to reign in their skyrocketing capital expenses, the drilling space witnessed intense competition, as multiple firms chased a single contract. This excess capacity, in turn, led to significantly lower utilization/dayrates.

The unprecedented period of hardship for the industry resulted in oil and natural gas driller Ensco plc (ESV - Free Report) swallowing smaller rival Atwood Oceanics in an all-stock deal worth $839 million, whetting investors' appetite for consolidation in the struggling sector. A few months down the line, offshore drilling giant Transocean Ltd. (RIG - Free Report) announced plans to acquire Norway-based contractor Songa Offshore for $3.4 billion, which came as the most expensive deal in the offshore drilling industry since the three-year oil slump period.

Now, with oil prices finally looking up, there are signs that offshore drilling demand is gradually rebounding from its lows. Some recent contracting activity suggests that oil and gas majors are again starting to warm up to the expensive offshore developments.

Despite early signs of recovery in North America, the current oilfield environment remains one of the most difficult. Yes, dayrates will rise from the ashes but worryingly, most of the new contracts will be for 2019. This is because clients are likely to take advantage of the lower rates while locking the awards for 2019 and beyond.

In a nutshell, notwithstanding the commodity price improvement, the structural oversupply and pricing pressure will weigh on the sector components’ operating margins through 2018.

Companies like Rowan Companies plc (RDC - Free Report) and Parker Drilling Company (PKD - Free Report) look to be in most trouble. Eating through backlogs without replacing them with new business, cash flow for these operators are likely to dry up further.

Continued Headwind for Gas-Weighted Companies

As winter season of peak demand winds down and production continues to trend higher, natural gas prices are expected to be rangebound.

Following a cold spell across the U.S. during the first half of January, weather turned warmer in the later part of the month, moderating further in February. This contributed to 17% less heating degree days (HDD) for February, which lowered demand for the heating fuel and put downward pressure on prices.

Meanwhile, U.S. dry natural gas production remains at record levels. Per EIA’s latest available monthly statistics, domestic output rose to a record high of 80.9 Bcf/d between November and December 2017. It is expected to trend higher in the coming months as huge reserves from the Marcellus and Utica shale regions find their way into storage facilities amid constantly falling production cost.

Now, with the withdrawal period set to end in about four weeks, we don’t see natural gas prices going above $3/MMBtu over the upcoming injection season in 2018 unless supplies spring up a downside surprise, which seems highly unlikely.

Consequently, natural gas-weighted exploration and production companies like Rex Energy Corp. REXX, Southwestern Energy Co. (SWN - Free Report) and Ultra Petroleum Corp. (UPL - Free Report) are in for a tough time.

Check out our latest Oil & Gas Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy.

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