Oil Stocks Poised to Play Catch-Up After Lagging Run-Up in Crude Prices

 In Market and Investment Insights

Until recently, energy stocks have failed to keep pace with the surging price of crude. Now Lead Energy Analyst Noah Barrett sees potential for well-managed, upstream and midstream companies to benefit from the highest spot prices for Brent and West Texas Intermediate oil in almost four years.

Key Takeaways

  • Saudi Arabia and Russia are showing no signs of breaking with coordinated production cuts, and while U.S. output is rising quickly, the risk is it will miss to the downside. Therefore there is a greater probability that crude prices will reach $90 a barrel than fall back below $60, while the spread between Brent and West Texas Intermediate is likely to remain wider.
  • The outlook is positive for energy stocks relative to the broader market through 2018 and beyond, as analysts raise their price decks for oil, leading to upward revisions in earnings estimates, higher price targets and making the sector more appealing to generalist investors.
  • As much as 80% of incremental U.S. production is concentrated in the Permian Basin, leading to bottlenecks that favor high-quality exploration and production companies, and midstream operators in the region that allocate capital responsibly and set budgets well below the spot price of oil.

So Brent prices and WTI prices have moved up pretty materially recently. Brent crossing $80 for the first time since 2014. WTI is currently in the low $70 range. If you look back on a one year a basis, the commodities rallied considerably, about 77%, but the energy equities have still materially lagged that. We still think that there’s a lot of room for energy equities to catch up to the recent performance in crude prices.

If we think about what’s driven that crude price, most of it has been driven by strong supply and demand fundamentals. So if I break down supply into three buckets, you really have OPEC plus Russia. I think they’re thrilled by the prospect of $80 or higher oil prices. We haven’t seen any signs yet that they want to break from the coordinated cuts and bring supply back into the market. The second bucket is U.S. production. U.S. production growth is going to be strong this year and the outlook on a multi-year basis continues to be strong. But I think the market expects that. And so if you think about risks to U.S. production, relative to consensus, I think it’s much more likely that we’ll surprise to the downside rather than the upside. That third bucket, the non-OPEC/non-U.S., I think we expect to be relatively flattish.

On demand, it looks great. It’s been really healthy. Even at $80 oil or something higher than that, there’s always the fear that you get into a price that incentivizes demand destruction. But even if you took a couple 100,000 barrels out of the market due to higher prices, absolute demand levels still remain very healthy.

With the strength in oil prices, you’ve seen analysts take their price decks up, so the consensus range, maybe it’s $65 to $75 or even $70 to $80. To us, I think if we break out of that consensus range for a sustainable period of time, to me the risk is to the upside. So essentially, I think the probability of $90 oil is much higher than the probability of oil falling back below $60 a barrel.

So we think the back drop for the energy sector relative to the broader market is pretty attractive for 2018 and beyond. A lot of sell-side analysts as I mentioned before, have taken their price decks up which will lead to positive earnings revisions, increased price targets and that may attract the generalist investor back into the energy space.

On the U.S. production side, the bulk of the activity is concentrated in the Permian Basin, so we estimate somewhere between 70% and 80% of U.S. production growth is coming from one region. And any time you have that much activity concentrated in a specific region, it can certainly lead to bottlenecks both on infrastructure, take-away availability of services.

One name that we think could be a beneficiary of this trend is Enterprise Product Partners.

They’re effectively a toll road for all the volumes that need to come through the U.S. downstream complex. They’re well positioned in every basin and essentially, growing U.S. production needs to go through a pipe to find a home. Enterprise is there to provide those solutions.

So those bottlenecks are one reason why WTI is trading at a pretty significant discount to Brent. Another reason is that the U.S. barrel, is a very light barrel and it’s not necessarily a good match for the U.S. refining complex. And if that crude isn’t a good fit for their system, how does that oil find a home? It needs to go into the export markets. So we think that WTI brand differential could persist.

Companies that are well positioned to benefit from the current trends that we see are high-quality upstream and midstream companies that are sticking to the strong message of disciplined capital allocation. So we like names like Anadarko Petroleum, Suncor Energy, Canadian Natural Resources, Occidental Petroleum and as mentioned before, Enterprise Products Partners.

The message of setting your budget at a price well below spot, and any incremental cash flow that we get from higher oil prices to the extent companies give that back to the shareholders either in the forms of higher dividends, share buybacks or even just keeping it on the balance sheet to improve their leverage metrics, we think that is resounding very well with investors and we like those companies that are doing that as opposed to taking that incremental cash flow and redeploying it back in the field in the form of higher activity.

Did you know our videos are also available as podcasts? Visit our iTunes page.

C-17315 0518