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Oil & Gas International E&P Industry Plagued by Supply Overhang

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The Zacks Oil and Gas - International E&P industry consists of companies based outside the United States and Canada focused on exploration and production (E&P) of oil and natural gas. These firms are engaged in finding hydrocarbon reservoirs, drilling oil and gas wells, and producing and selling these materials to be refined later into products such as gasoline.

Let’s take a look at the industry’s three major themes:

 

  • Brent crude, the international benchmark, bounced back above $65 per barrel after the United States and China agreed on a so-called phase one deal that is seen as a step to thawing of trade tensions. Also, boosting oil, the OPEC+ group announced that it will cut output by as much as 500,000 barrels per day from Jan 1 for three months. But the main obstacle in tightening the market and preventing crude prices from rising much further is the seemingly relentless growth in American oil production from the shale patch. Official figures show the U.S. churning out nearly 13 million barrels of oil per day – an all-time high that is jeopardizing OPEC-led efforts to cut supplies and prop up prices.

 

  • Meanwhile, bearishness continues to grip the natural gas market. With output in the lower 48 states recently hitting a record 92.8 Bcf per day, there is little room for prices to improve meaningfully from their current levels of around $2.3 per MMBtu. Operators in oil-dominated shale basins like the Permian, Eagle Ford and North Dakota are also struggling with significant natural gas flaring - a largely unwanted derivative that emerges alongside crude production in the region. Agreed, the fundamentals of natural gas consumption continue to be favorable on growing demand by electrical utilities, booming exports to Mexico, large-scale liquefied gas export facilities and higher usage from industrial projects. However, record high production in the United States and expectations for healthy growth through 2020 means that supply will keep pace with demand. Therefore, prices are likely to trade sideways but for weather-driven movements. In other words, natural gas might experience short-lived surge based on positive weather forecasts but any powerful turnaround looks unlikely at the moment.

 

  • Over the past few years, energy producers worked tirelessly to cut costs to a bare minimum and look for innovative ways to churn out more oil and gas. And they managed to do just that by improving drilling techniques and extracting favorable terms from the beleaguered service producers. Moreover, driven by operational efficiencies, most E&P operators have been able to reduce unit costs and live within their cash flows. All of these factors, together with production growth and capital discipline have resulted in healthy free cash flows. With cash generation expected to remain robust even at relatively low oil prices, there is strong potential for greater return of capital to shareholders through dividend growth and stock buybacks.

 

Zacks Industry Rank Indicates Subdued Outlook

The Zacks Oil and Gas - International E&P is a 10-stock group within the broader Zacks Oil - Energy sector. The industry currently carries a Zacks Industry Rank #190, which places it in the bottom 25% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates dim near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s position in the bottom 50% of the Zacks-ranked industries is a result of negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts are pessimistic on this group’s earnings growth potential. While the industry’s earnings estimates for 2019 have decreased 89.1% in the past year, the same for 2020 have slumped 96.3% over the same period.

Despite the bleak near-term prospects of the industry, we will present a few stocks that you may want to consider for your portfolio. But it’s worth taking a look at the industry’s shareholder returns and current valuation first.

Industry Lags Sector & S&P 500

The Zacks Oil and Gas - International E&P industry has lagged the broader Zacks Oil - Energy Sector as well as the Zacks S&P 500 composite over the past year.

The industry has declined 3.8% over this period compared with the S&P 500’s gain of 26.2% and broader sector’s decrease of 1.4%.

One-Year Price Performance

 

 

Industry’s Current Valuation 

Since oil and gas companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of noncash expenses.

On the basis of the trailing 12-month enterprise value-to EBITDA (EV/EBITDA) ratio, the industry is currently trading at 6.95X, lower than the S&P 500’s 11.73X. It is, however, above the sector’s trailing-12-month EV/EBITDA of 4.91X.

Over the past five years, the industry has traded as high as 71.98X, as low as 6.95X, with a median of 15.96X.

Trailing 12-Month Enterprise Value-to EBITDA (EV/EBITDA) Ratio

 

 

 

 

 

Bottom Line

Despite OPEC's continued production cut pledge, the world will still face a supply surplus in 2020 on North American shale production growth. However, the breakthrough in the trade war is likely to provide some tailwinds to the outlook for demand growth. Slowing production growth in the shale region will also help the market to rebalance and support higher oil prices. Finally, greater financial discipline practiced by the energy companies have raised expectations that supply growth could slow down sooner than later.

Natural gas futures, meanwhile, are likely to remain sedate on surging supplies.

Despite the downbeat mood in the industry, we are presenting a stock with a Zacks Rank #2 (Buy) that is well positioned to gain amid the prevailing challenges. There are also three stocks with a Zacks Rank #3 (Hold) that investors may currently hold on to.

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

Kosmos Energy Ltd. (KOS - Free Report) : Kosmos Energy is an oil and gas explorer focused on offshore Ghana, Equatorial Guinea and U.S. Gulf of Mexico. The dual-listed (NYSE & London) company – carrying a Zacks Rank #2 – has an expected earnings growth of 102.1% for this year.

Price and Consensus: KOS

 

 

Vermilion Energy Inc. (VET - Free Report) : Vermilion Energy is an oil and gas explorer with producing properties in Europe, North America and Australia. The company carries a Zacks Rank #3 and have surpassed estimates in two of the last four quarters, the average being 63.4%.

Price and Consensus: VET

 

 

Tullow Oil plc (TUWOY - Free Report) : Tullow Oil is a London-based hydrocarbon producer and explorer with main focus on Africa. The Zacks #3 Ranked stock has an expected earnings growth of 100% for 2019.

Price and Consensus: TUWOY

 

 

Cairn Energy plc (CRNCY - Free Report) : This Edinburgh, UK-based upstream operator has key operations in Senegal apart from its home country. Cairn Energy carries a Zacks Rank #3 and has an attractive expected earnings growth of 101.7% for this year.

Price and Consensus: CRNCY

 

 

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