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State of the sector: energy

Be selective as oil prices may stay within a narrow range over the medium term.

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During the majority of the past two decades, one of the major themes setting the backdrop of the U.S. energy sector was the inability of supply for both crude oil and natural gas to keep up with demand for these commodities. As a result, commodity prices soared.

Throughout this period of upwardly trending commodity prices, there were several boom-bust cycles of supply and demand. These cycles typically unfolded as follows: Economic growth accelerated and drove up demand for energy commodities; commodity prices and corporate profits increased; energy companies overbuilt capacity and supply; the economy decelerated; the combination of reduced demand and overcapacity caused a decline in commodity prices and corporate profits. For the most part, in each new cycle over this period, commodity prices eventually increased to a high enough level to absorb all the previous spare capacity, sparking the build-out of new capacity.

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This historical environment of commodity price inflation provided a tailwind to the entire energy sector. The share prices of lower quality energy producers—those that borrowed significant capital to search and drill for oil or natural gas—generally were rewarded more by investors, and benefited most from the favorable backdrop of commodity inflation. Escalating commodity prices produced incrementally higher revenues that were critical to servicing debt. Companies with greater willingness to take on debt and significant operational leverage often outperformed higher-quality, financially stable companies that were not as highly leveraged.

The setting may have changed

The macro backdrop going forward could be quite different. In my view, the potential for upwardly trending commodity inflation is limited. During prior cycles, when the per-barrel price of crude oil doubled, it served as a hindrance to the economy, but it didn’t always cripple the economy.1 If the price of oil were to double today as it has done in the past, it could negatively impact the economy more severely because oil and gasoline products are now a higher percentage of consumer spending.2 Today, the upside to oil prices is limited by elasticity of demand and repercussions for the global economy.

At the same time, the downside to the prices of crude oil and natural gas is limited by high development costs via innovative shale-drilling technologies to produce these commodities. While the costs to develop natural gas have somewhat flattened, the costs to develop crude oil via U.S. shale locations continue to rise.

Historically, the price of both natural gas and oil have oscillated between the marginal cost of producing these commodities and the price of demand destruction, with occasional declines below marginal cost over short-term periods. Generally, companies are only going to invest capital to produce commodities if it is profitable to do so. Therefore, the downside to commodity prices is limited, because commodity prices are likely to move in line or above costs over the long term.

For these reasons, there are unlikely to be major moves in commodity prices; they should remain range-bound over the medium term, barring an unexpected acceleration or deceleration of the global economy.

Companies poised to benefit from production cost deflation

In this new era of shale drilling, production growth, and the hope for U.S. energy independence, the higher-quality companies— meaning those with limited debt, declining cost structures, and strategic land resources in the most fertile regions—are best positioned to achieve higher revenue growth and profit margins.

Companies with drilling capabilities in prime production basins have seen their production and development (i.e., drilling) costs plummet, even though overall costs across the industry are either flat (natural gas) or rising (crude oil). Such companies have a strategic advantage over those with higher cost structures.

Earnings trends

Corporate earnings growth in the energy sector exceeded Wall Street analysts’ expectations for the second straight quarter ending March 31, 2013 (see the chart right).

The better-than expected results over this period were largely driven by exceptional year-over-year earnings growth among refining companies, which benefited from a widening spread between lower-priced West Texas Intermediate (WTI) crude prices—the U.S. benchmark for oil—and higher-priced Brent North Sea crude—the prevailing global benchmark for oil. Historically, the pricing spread between these two sources of oil has been negligible because it has been easy to move the global volume of crude oil produced from one location to another. But during the past few years, the increased volume of onshore WTI oil produced by midcontinent U.S. states as a result of innovative fracturing technology, combined with the absence of adequate U.S. infrastructure to inexpensively divert this new supply to international markets, resulted in depressed WTI prices and a widening of the WTI-Brent pricing spread. More recently, that spread has tightened.3

Assessing valuation

The valuations of energy stocks are historically low. For example, energy stocks are close to the cheapest they have been in more than 15 years (see the chart right) based on a ratio of enterprise value to fixed assets (i.e., property, plant, and equipment). Importantly, energy stocks on average have become cheap enough that they have started to act as a catalyst for motivating activist shareholders.

However, the valuations of certain companies that have prime drilling acreage in key shale rock basins and declining costs structures are generally higher than the sector as a whole. In my view, the higher valuations of this subset of companies are justified by their competitive advantages.

Outlook for energy stocks

My expectation is that there will be a relatively flat commodity price environment going forward, which means that stock selection within the energy sector may become a more important factor in generating strong performance than during prior years featuring an extended backdrop of rising commodity prices.

One approach that could pay off in this environment is to focus on E&P companies with declining cost structures that are well positioned in the key shale rock basins of the United States. Further, it is likely that the spread between WTI crude oil and Brent crude oil will continue to narrow as more pipeline capacity is completed to bring midcontinent oil to the coast, leading to a potential rotation among the winners and losers in the sector.

Overall, investors have a unique opportunity to own energy companies at near-record-low valuations during a period when new drilling technologies are creating a fundamental enhancement (increased U.S. supply) to the global economy. Historically, buying energy stocks during periods of low valuations has been an effective approach to generating favorable returns over an extended period.

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1. The per-barrel price of crude oil rose from $18 in 2002 to $77 in 2006, and the U.S. economy did not experience a recession. Similarly, the perbarrel price rose from $10 in 1986 to $22 in 1987, also without a recession. Crude oil price represented by West Texas Intermediate (WTI) crude oil at Cushing, Oklahoma. Source: Bloomberg, as of June 28, 2013.
2. On average, U.S. households spent 4% of pretax income on gasoline during 2012. From 1986 to 2004, U.S. households on average spent less than 3% on gasoline. From 1994 to 2003, the average percent of pretax income spent on gasoline was near 2%. Source: U.S. Energy Information Administration.
3. The price spread between (lower-priced) West Texas Intermediate (WTI)- sold domestic crude oil and (higher-priced) Brent North Sea-sold crude oil peaked at –29.6 in Sep. 2012, and declined to –4.9 on June 28, 2013. Source: Bloomberg, as of June 28, 2013.
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