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Oil & Gas Stock Outlook - Aug. 2015

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Crude Oil

The free fall in oil prices have made ‘energy’ the most talked-about sector of the entire market in 2015, apart from the fact that its performance has been the worst. Year-to-date, ‘The Energy Select Sector SPDR’ has posted a loss of 25%. On the other hand, the broad-based Dow Jones Industrial Average and the S&P 500 index shed just 12% and 9%, respectively, over the same period.  

As of now, crude prices are trading below the key psychological level of $40-a-barrel after hitting a new 6-1/2 year low of $37.75 recently. This, despite a short spike that saw the commodity scale a year-high of $61.43 per barrel in June.

Oil is facing the heat on several fronts. Perhaps, the most important of them pertains to the mounting worries about China’s crude demand. In particular, the Asian giant’s currency devaluation has stoked speculation about soft economic growth in the world’s No. 2 energy consumer.  

What’s more, in the absence of production cuts from OPEC, the effects of booming shale supplies in North America and a stagnant European economy, not much upside is expected in oil prices in the near term. Moreover, a stronger dollar has made the greenback-priced crude more expensive for investors holding foreign currency. The Iranian nuclear framework agreement, which has the potential to release more of the commodity in the already oversupplied market, has put the final nail in the coffin.

As it is, with inventories near the highest level during this time of the year in 80 years at least, crude is very well stocked. On top of that, OPEC members (like Saudi Arabia) have made it clear time and again that they are more intent on preserving market share rather than attempting to arrest the price decline through production cuts. Therefore, the commodity is likely to maintain its low trajectory throughout 2015.

This has forced the oil companies and associated service providers to make deep cost cuts by reducing their workforce. Oilfield services behemoths like Halliburton Co. (HAL - Free Report) , Schlumberger Ltd. (SLB - Free Report) and Weatherford International plc (WFT) were the first to respond to the worsening situation, announcing substantial redundancies earlier in the year. Of late, they have been joined by integrated majors including Royal Dutch Shell plc (RDS.A - Free Report) and Chevron Corp. (CVX - Free Report) .

In the medium-to-long term, while global oil demand will be driven by China – which continues to be the main catalyst to liquids consumption growth despite the current slowdown – this will be more than offset by sluggish growth prospects exhibited by Asian and the European economies.

In our view, crude prices in the next few months are likely to exhibit a sideways-to-bearish trend, mostly trading in the $40-$50 per barrel range. As North American supply remains strong and demand looks underwhelming, we are likely to experience a pressure in the price of a barrel of oil.

Natural Gas

"It's cleaner, it's cheaper and it's domestic."

- Legendary energy entrepreneur T. Boone Pickens, in reference to 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.

Statistically speaking, the current storage level – at 3.030 trillion cubic feet (Tcf) – is up 488 Bcf (19.2%) from last year and is 80 Bcf (2.7%) above the five-year average. Expectedly, this has taken a toll on prices. Natural gas peaked at about $13.50 per million British thermal units (MMBtu) in 2008 but fell to sub-$2 level in 2012 – the lowest in a decade.

Though it has recovered somewhat, at around $2.70 now, the commodity is still way off the heights reached seven years back. In fact, natural gas been trading range bound over the last couple of quarters with investors looking for direction. It has been stuck between $2.50 and $3 per MMBtu over the past 5 months.

In response to continued weak natural gas prices, major U.S. producers like Chesapeake Energy Corp. (CHK - Free Report) , Cabot Oil & Gas Corp. (COG - Free Report) and Range Resources Corp. (RRC - Free Report) have all taken significant cost-cutting measures, including a reduction in their capital expenditure budgets for the year.

With production from the major shale plays remaining strong and the commodity’s demand failing to keep pace with this supply surge, natural gas prices have been held back. Even the summer cooling demand has been of little help. What’s more, with improved drilling productivity offsetting the historic decline in rig count, and expectations of tepid heating demand with the imminent arrival of soft late-summer temperature, we do not expect gas prices to rally anytime soon.

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 #23, comfortably placing it into the top 1/3rd of the 260+ industry groups – the only component to achieve the feat.

The ‘Oil and Gas Drilling’ – with a Zacks Industry Rank #90 – moves just out of the top 1/3rd and into the middle 1/3rd. There, it is joined by the ‘Oil – International Integrated’, ‘Oil–C$ Integrated’, ‘Oil – U.S. Exploration and Production’, ‘Oil – Production/Pipeline’ and ‘Oil – U.S. Integrated’ with respective Zacks Industry Ranks #94, #107, #145, #161 and #170, respectively.  

The remaining sub-sectors – ‘Oil/Gas Production Pipeline MLP,’ ‘Oilfield Services’ and ‘Oilfield Machineries and Equipment’ – are featuring in the bottom one-third of all Zacks industries with respective Zacks Industry Ranks of #186, #187 and #192.

The exact location of these industries suggest that the general outlook for the oil/energy space as a whole is leaning toward ‘Negative.''

EARNINGS TRENDS

A look back at the Q2 earnings season reflects that the overall results of the Oil/Energy sector were the weakest in several quarters, dragging down the aggregate growth picture for the S&P 500 index.

Faced with plentiful supplies and lackluster demand, the meltdown in crude prices continued throughout during this period on. Moreover, a stronger dollar made the greenback-priced crude pricier for investors holding foreign currency. The turn of events in Greece, Iran and China also created pressure.

Before discussing current quarter estimates, let’s take a look at the Q2 earnings season, which is almost behind us. For the 97.5% industry components that have come out with their numbers – comprising 99.3% of the sector market capitalization – earnings fell by a whopping 60.4% year over year, following a 54.3% drop witnessed in the previous quarter. Things have been bad on the revenue front too, which was down 31.6% in the June quarter after declining 34.7% in the previous three-month period.

However, the sector has been somewhat more encouraging in terms of beat ratios (percentage of companies coming out with positive surprises). While the earnings “beat ratio” was decent at 69.2%, the revenue "beat ratio" was more modest, at just 53.8%.

Predictably, things are looking bleak for the upcoming Q3 earnings season. This is not surprising, considering that oil recently plunged as low as $37-per-barrel, in the process dragging down estimate revisions. The Oil/Energy sector’s earnings are expected to crash 62.1% from the third quarter 2014 levels, while the top-line is likely to show a drop of 35.4%.

For the S&P 500, earnings and revenues are estimated to show year-over-year fall of just 5.1% and 4.7% during the three months ended Sep 30, 2015, respectively. This puts the Oil/Energy sector in a bad light when compared to the broader markets.

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