Oil has had a wild ride in the past 10 years, plunging from $145 a barrel to below $30, only to double again to a recent $62. Yet the latest rebound has done little to lift long-suffering energy stocks off the mat. Investors' big fear is that prices will plummet again as U.S. shale producers flood the market with crude and the Organization of Petroleum Exporting Countries, or OPEC, reneges on its year-old agreement to keep supply in check. Such is Wall Street's disdain for the sector that energy today accounts for just 6% of the Standard & Poor's 500 (.SPX), roughly half the weighting of a decade ago.
You'll get a different, and decidedly more upbeat perspective, however, from the members of Barron's 2018 energy roundtable, who met in mid-February to discuss the outlook for oil and natural gas and other energy stocks, including master limited partnerships, or MLPs.
Our panelists see upward pressure on crude prices as global demand continues to exceed supply, especially as U.S. producers and oil-service companies grapple with infrastructure and manpower constraints. They are also cheering the industry's new focus on capital returns, after years of excessive capital spending. A keener attention to free cash flow and healthier balance sheets should translate into higher dividend payments and more stock buybacks, producing better returns for investors.
This year's roundtable features four experts who approach the oil patch from different perspectives. Helima Croft, global head of commodity strategy at RBC Capital Markets, studies the geopolitical picture for the energy market. Charles Robertson, whose official title at Cowen is managing director, energy–oil & gas exploration and production, specializes in U.S. producers. John Dowd manages the $2 billion Fidelity Select Energy Portfolio (FSENX), which owns a variety of energy and oil-service stocks, and Gregory Reid is president of Salient MLP Complex, an investment manager specializing in energy infrastructure.
To learn more about their views, read on.
Q: Oil prices have roughly doubled in the past two years to a recent $62. Helima, you're the big-picture expert on this panel. Where are prices heading from here, and what will drive them?
Helima Croft: The fundamental backdrop for oil is constructive. There is a push-pull right now on the supply side between resurgent U.S. production and geopolitical supply disruptions. Sometimes the market focuses on only one side of the story, forgetting what is happening on the other. With U.S. production surpassing 10 million barrels a day, the current theme is U.S. dominance. Will excess supply lead to another oil-price crash? On the other side, we have key producers whose output is falling fast.
Take Venezuela: Our base case is that Venezuelan production could be down year on year by 700,000 to 800,000 barrels a day, but it potentially could fall by a million barrels a day, or more.
Q: What would that mean for the oil market?
Croft: Because of seasonality, the oil market is at a soft point now. But if we were to lose a lot of volume out of Venezuela, that is your breakout story in oil. The market is tightening and rebounding. OPEC's resolve to limit supply is firm. [OPEC and several non-OPEC producers struck an agreement in 2016 to cut production by 1.8 million barrels of oil a day; in November, OPEC and a group of countries led by Russia agreed to extend the production cuts through the end of this year.] By year end, we see WTI [West Texas Intermediate, the U.S. benchmark crude] trading in the $60s and Brent crude [the global benchmark] in the mid-$60s. [Brent traded Thursday at $65.95.]
But there is a high-risk scenario in which Venezuela's production falls off quickly on the back of a tightening market. We are also watching Libya and Nigeria. The risk isn't that they will put more barrels on the market in 2018, but that production in both countries will start to decline. Libya will be holding elections. The Islamic State, or ISIS, is resurgent in the country's oil crescent, and we are seeing renewed attacks on Libyan energy infrastructure. A lot of things in Libya could be problematic for keeping production online.
Q: In other words, prices might surprise on the upside. Greg, how does the market look to you?
Gregory Reid: As an investor in midstream master limited partnerships [midstream MLPs focus on gathering, storage, and transportation of oil, gas, and natural-gas liquids, or NGLs], we focus more on volumes. But we have to pay attention to price. We are also more focused on North American production. In terms of supply growth, the U.S. is enjoying a nice pricing umbrella as a result of OPEC's and Russia's restraint. This is particularly positive for companies in the Permian Basin [a large oil-producing region in western Texas and New Mexico]. We are seeing strong volume growth and a lot of activity in pipelines proposed and then, hopefully, built out of the Permian, to export out of Corpus Christi and the Houston Ship Channel. The export opportunity is a booming part of our business. We are going to see a number of liquefied natural-gas, or LNG, facilities come on-line in the next two or three years.
On the demand side, an ideal environment exists. This is a unique period of synchronized global growth, one of the best since World War II. After two or three years of oversupply, the oil market looks pretty attractive. We expect WTI to spend most of the year between $55 and $70 a barrel. I wonder, though, whether Russia will get tired of subsidizing U.S. production and back away from production restraints this summer. I expect that.
Q: Charles, what is your view as an exploration-and-production specialist?
Charles Robertson: Our price target for oil is between $55 and $60 a barrel, which seems to be a bearish view here, although we are constructive on crude. Demand has surpassed our expectations. On the supply side, there are infrastructure constraints in the Permian and elsewhere, as well as personnel shortages in oil services. As a result, we don't see a big run-up in U.S. shale-oil production in the first half of 2018. The E&P companies are waiting until the second half of the year, when additional infrastructure comes online. E&P companies are exercising capital discipline. In part this has been imposed by investors, and in part production in the Permian has been growing at such a high rate that it is stretching the ability of infrastructure, such as gas processing, to keep up.
John Dowd: What keeps the lid on prices for the time being?
Robertson: Refineries are going into turnaround [a planned break for maintenance]. It is seasonal. Much will depend on what OPEC does this summer. E&P companies want to know the OPEC exit strategy before materially ramping up production. There is hesitation in the market, although we find the bias to the upside for oil.
Q: John, how do you size up the market?
Dowd: The story line in crude in the past year has been inventories. Supply has been less than demand, and inventories have been drawn down at a rate of about a half-million barrels a day, the fastest pace in history. Big inventory draws drove up the front month [shortest-duration futures contract] for crude. But the market has been skeptical of the sustainability. The long-dated crude price hasn't moved up. The market's view had been that technological innovation plus an abundance of access to capital would enable U.S. producers to ramp up production at will. But that is in the process of changing.
Q: How so?
Dowd: The elasticity of supply isn't as robust today. It is difficult to ramp up activity. As Charles stated, the problem is a lack of oil-service capacity. It is also limitations on pipeline takeaway capacity in oil and natural gas. It is traffic jams in Midland [Texas]. We haven't seen a full-fledged acceleration in the oil-services industry, given today's low unemployment rate in the U.S. It's simplistic to think that a $10-a-barrel increase in the price of oil will be temporary because U.S. companies will respond by accelerating production.
For many years, E&P was a deflationary industry. Every year, productivity per well surged by 20% to 30%. That is slowing because of logistics issues. Also, companies have been chastised by Wall Street about their low returns on capital.
This is forcing a shift in mind-set; managements are looking to improve returns rather than invest in science. I don't think that we are going to see a step-function change in well productivity.
Q: Your fellow panelists are nodding their heads vigorously in agreement. What is your target price for oil?
Dowd: I spend more time trying to pick the stocks than the oil price, so I'm going to evade that question.
Q: Although oil prices have risen, many energy stocks are depressed. What is the best argument for buying the stocks today?
Reid: Mine is pretty easy. Midstream MLPs are down about 45% from levels of three years ago. They are trading at discounts of 10% to 20% relative to five- and 10-year average Ebitda [earnings before interest, taxes, depreciation, and amortization] multiples. Most sectors of the Standard & Poor's 500 index, including utilities and oil-services stocks, are trading at premiums to long-term averages. We are probably late in the economic cycle, and people want to take less risk. MLPs are a good place to hide, with dividend yields of 6% to 8% on average. You get paid to wait for the recovery.
Dowd: Energy stocks have underperformed over the past decade because oil prices have come down. A decade ago, oil traded above $100 a barrel. The decline has been a serious headwind. But there have been significant divergences across companies. The leaders in shale have done well.
Broadly speaking, I agree with the valuation call not just for MLPs but also across the sector. In the past year, oil prices rose, but the stocks underperformed the market significantly. Relative price/earnings and price/cash flow multiples have contracted. Integrated oil companies have 4%-to-8% free-cash-flow yields, often better than the market. E&P companies are trading at some of the lowest multiples relative to the integrateds in a decade. The U.S. oil industry has become the lowest-cost producer globally. Now it is possible to invest in companies that will grow their production, earnings, and cash flow by 20% a year for the next five or 10 years, in a flat $50-to- $60 oil-price environment.
Robertson: Since 2015, the prior peak in U.S. oil production, many E&P companies have cleaned up their balance sheets. They are more disciplined about capital spending. The largest, diversified oil companies aren't growing production by 20% a year, but a company like Pioneer Natural Resources (PXD) is doing so.
Dowd: I think many investors are reluctant to make a call on the commodity price. That said, many companies are growing without reliance on the commodity-price environment. Diamondback Energy (FANG) is a low-cost Permian producer that has been aggressively growing production. Earnings per share have doubled since 2014, while oil prices dropped 40%. Its success is reflected in a near-record stock price. What has made the stocks move, and will make them move, is increased cash flow. When oil was $28 a barrel two years ago, the U.S. E&P industry wasn't generating operating cash flow. Since then, E&P companies have adjusted their cost structure massively, and reined in investment. The big integrated oil companies have done the same.
Croft: If the U.S. has become the low-cost producer, Saudi Arabia is a relatively high- cost producer. Oil essentially funds the entire state apparatus. As for Russia, the person who makes the decision about whether or not to stick with the deal is [President] Vladimir Putin. Consider how cooperating with OPEC works for him. According to the latest Arab Youth Survey, published last year, Russia is now the preferred international partner of Middle East youth, surpassing the U.S. The fact that Russia can have dealings with both the Saudis and Iranians, and pay no price with either side, is stunning. Russia is also the most influential country in Venezuela. Russia is doing huge deals with sovereign-wealth funds in the Middle East. Russia is proposing to increase education, infrastructure, and health spending for the first time in several years. That is the war chest Putin has because of a higher oil price. For Putin's foreign-policy ambitions, oil is critical.
Reid: Putin has played this brilliantly. The U.S. left a leadership vacuum and he jumped in. Now he can export arms and work both sides of the Sunni-Shiite divide.
Q: This sounds like a foreign-policy roundtable. Returning to energy stocks, which look most attractive to you?
Reid: We like Genesis Energy (GEL), based in Houston. The company voluntarily cut its distribution by 30% last year, believing it could better use the money to pay down debt. The stock fell from about $26 to a recent $20 a share after the distribution was cut. We figured investors would sell the shares in December to take tax losses, and then the stock would rebound. It jumped 10% to 12% in early January but then rolled over, like the rest of the MLP market. Now it yields 10%.
Genesis trades for about 10 times 2018 estimated Ebitda and has 1.5 times dividend coverage. It is an excellent value, given that the group is trading for 11.5 to 12 times Ebitda and has dividend coverage of 1.2 times. Genesis is a Warren Buffett kind of business: high profit margin, attractive yield, low valuation.
Targa Resources (TRGP) is another name we like. It is well positioned in the Permian Basin. Targa had a need for equity capital, and investors were expecting it would sell more stock. Instead, early this month, it announced an $1.1 billion joint venture with a private-equity firm to provide off-balance-sheet development capital to build three new midstream projects without diluting current shareholders. The company can then buy the assets back in two or three years when they are fully built. Targa controls 20% of all the natural gas and NGL gathering and processing capability in the Permian Basin. Once the bottleneck of equity issuance was removed, the stock jumped 3%, and the rally could have legs. Targa yields about 8%.
Q: Charles, which stocks appeal to you?
Robertson: Anadarko Petroleum (APC) and Noble Energy (NBL) were both down 23% last year. Both companies have exposure to Colorado, and their stocks were impacted by a fatal house explosion in the state near an Anadarko well. The good news for E&P operations is that it appears the gubernatorial candidates don't support the 2,500-foot setback rules that were proposed by environmentalists for wells. So we don't see a potential political impact on production in the DJ Basin [in Colorado and neighboring states], which is critical to both companies.
In Noble's case, we see a lot of upside coming from production in the Delaware Basin [in Texas]. As John discussed, execution is key. The company is in the sweet spot of the southern Delaware Basin [in Western Texas] along with Occidental and Concho Resources (CXO). We see a bit of infrastructure concern there, but they have signed deals to get production down to the Gulf Coast.
The Delaware Basin is Noble's U.S. story. But what will really define 2018 is the completion of the Leviathan field project, the company's Israeli natural-gas asset. Noble has contracts for about 90% of the output for its Leviathan facility, and is working on contracting the remainder, which will happen this year.
Tamar, Noble's current project in Israel, is operating at near-full capacity. We think Israel will get recognized by investors this year. Noble has materially cleaned up its balance sheet and it hasn't received recognition for its success.
Q: What kind of upside do you see for the stock?
Robertson: It could rise to $40 from around $28 today, and there is further upside potential. We expect Anadarko to continue returning cash to shareholders. We expected a quarterly dividend increase, and got one this month [the company raised its payout 400%, to 25 cents a share from five cents]. Anadarko also increased its stock-buyback program to $3 billion from $2.5 billion. Anadarko has led on drilling technology in the DJ Basin, and hasn't received recognition for its execution. Most investors say the company is a great operator offshore, but it is great onshore, as well. Shares are trading around $60 and could rise to $70.
Q: Are dividends and stock buybacks likely to rise across the energy sector?
Dowd: The industry has concluded that the business model of borrowing money to grow oil production is broken. Reinvestment rates are falling and dividends are increasing. Based on consensus estimates, more than half the E&P companies I look at will generate free cash flow this year. That is a big difference from the past. The industry has picked up on Wall Street's desire for higher returns and is acting on it.
Reid: In our pond—we track about 60 stocks—57% of companies grew their dividends in last year's third quarter, by 16% on average. Another 19 grew their dividends or didn't cut them. Six cut their dividends, by 40% each, and their stocks fell 40%. The early read on the fourth quarter is no dividend cuts, and more companies growing dividends. If you have a 7% yield and grow your dividend 10% or 12% or 15%, that's a powerful combination. With a more favorable commodity-price backdrop and strong volume growth, the industry is back in growth mode for dividends.
Robertson: Larger-cap E&P companies are looking to raise their dividends. Anadarko and Pioneer have already done so. Other companies that cut their dividends in the past could restore them in part. Natural-gas producers are starting to focus on free cash flow as well, something we wrote about last year. Refiners went through this transition years ago, where they had always focused on growth rather than the return of cash. Natural-gas producers such as Cabot Oil & Gas (COG), EQT (EQT), and Range Resources (RRC) are starting down this path. That will change who the buyers of these stocks are. It took the refiners' stocks a few years to stabilize as the investor base changed. Among natural-gas companies, the free cash flow will arrive for most producers in 2020.
Dowd: It is hard to overstate the importance of the shift to a return-on-capital focus among management teams in this industry. I have been surprised by how many management teams are willing to change their compensation metrics to incorporate return on capital. Several years ago the concept would have been disparaged. Today, companies are endorsing it, in part because it is what Wall Street wants, and in part because the business is at a different point in the cycle.
When shale was first discovered, every energy company had to secure its position. The industry was in a land-grab, resource-grab mode. Now that the acreage has been secured, companies are spending 90% of their money on drilling wells and only 10% on infrastructure. At this stage, return on capital should improve.
Q: Which companies in your portfolio are doing well on this score?
Dowd: Companies that have drilled the most have learned the most, and have the lowest cost structure. EOG Resources (EOG) is one of the largest positions in my fund. It has drilled about a third of the high-quality wells in this country, as measured by the number of wells with initial production of more than 1,600 barrels of oil per day. It is a big operator in Eagle Ford [a Texas shale play], the Permian, and the Bakken [in the northern U.S. and Canada]. Its cost structure has been visibly better than peers. Its well productivity has been among the best. EOG, by drilling the most wells, is making the most mistakes and learning from them.
Halliburton (HAL) is another big holding. It is the biggest pressure-pumping company in the U.S. and has the advantage of scale. It is one of the top five logistics companies in the U.S. across all industries. The company builds its own pressure-pumping equipment, whereas the rest of the industry buys it. That means some pressure-pumping companies are talking about a year's lead time to get new equipment. Halliburton is talking about two months. Halliburton has been focused on the same business lines for a very long time. That constancy of purpose has shown through in returns on capital relative to peers.
Pioneer is also one of my top 10 holdings. It is one of the biggest E&P companies in the Permian. Its goal is to drill two million barrels a day over the next 10 years, which would translate into production growth of 19% to 24% annually. Pioneer thinks it can fund that with $58-a-barrel oil prices. The challenge, with unemployment low, is to find companies that can execute.
Robertson: Two Targa gas-processing plants are coming on-line this year. The ones coming on this year will process 200 million cubic feet [MMcf] a day of natural gas, and the ones coming on next year, 250 MMcf a day. Pioneer Natural Resources, which owns an interest in these plants, worked with Targa to increase the capacity to process even more natural gas. Five years ago, an E&P company never would have thought this way.
Reid: One thing we look for in a company is sponsorship. Pioneer, in this case, is driving the volumes through Targa's system. We like Shell Midstream Partners (SHLX), also a well-sponsored name. Royal Dutch Shell (RDS/A) took its midstream business public in the U.S. in 2014 to highlight the value of midstream assets, which trade at 12 to 14 times Ebitda, compared with the E&P company, which trades at around eight times Ebitda. The midstream business is perceived to be more reliable. It is fee-based. The sponsor is an investment-grade supermajor. You can't get much better than that. Shell Midstream yields about 6%. It issued equity recently that depressed the stock price by 10%. Now you can buy the stock at a cheaper price. The consensus is that the distribution will grow about 20% in 2018 and in the mid-teens in 2019. With $1.5 billion to $2 billion in projected Ebitda at Royal Dutch Shell and another $1 billion of Ebitda from projects being evaluated, Shell Midstream has a visible runway for growth.
Q: Do the major integrated oil companies' shares look appealing at today's prices?
Dowd: The E&P space is more attractive, but it depends on the metric. Integrated oil companies have done a commendable job reducing their capital spending and cost structure, and adjusting to lower commodity prices. Many have had major multiyear projects come on in the past couple of years. Now, those big projects are behind them and they get to enjoy the cash generation for decades.
Energy companies buying back stock
Croft: The major integrated oil companies, or IOCs, see a lot of growth opportunities in the U.S. Think of how difficult it used to be for the IOCs to operate in a place like Nigeria. They had to deal with pipeline destruction, the kidnapping of oil workers, and public campaigns against the companies. With the discovery of new resources in the U.S., they can be more selective about where they operate.
Reid: Recently, Exxon Mobil (XOM) said it will spend $50 billion on U.S. projects over the next seven years. I almost fell out of my chair when I heard that. Exxon hasn't spent that kind of money here in a long time.
Croft: The growth of the shale business in the U.S. liberates both the oil companies and U.S. consumers.
Q: Natural gas is down to $2.60 per million British thermal units from $8 a decade ago. What is the outlook for gas and gas producers?
Reid: The U.S. is blessed with abundant natural-gas resources, but natural-gas prices could be range-bound between $2.50 and $4 for a long time. Pipeline bottlenecks in the Marcellus and Utica [shale regions] have kept production flat or declining.
Robertson: We see natural gas trading longer-term in the $2.50 to $3.50 range. Ultimately, the U.S. gas solution for the supply-and-demand balance will be LNG exports, but the business will remain challenged for the next few years.
Q: How should an investor in oil and gas stocks gauge the threat from renewable energy?
Croft: Demand for conventional fossil fuels remains robust, but the leaders of the big oil-producing countries don't want to be caught by surprise if demand shifts. There is a tremendous hedging of bets by the men in the palaces regarding the actuarial table for oil. The United Arab Emirates is the most forward-leaning of these countries. In Saudi Arabia, Prince Mohammed bin Salman and his team have advocated investing in renewables alongside conventional fossil fuels. The young leaders of the Middle East want to be well placed if the shift to other energy sources happens faster than expected.
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