By Eric Chenoweth
The energy stock rally stalled out in the fourth quarter of 2009, with market valuations still resting very close to our fair value estimates in many cases. Fears that natural gas price weakness will extend into 2010 gained traction after third-quarter results were reported.
Still Waiting for a Gas Supply Contraction
We were surprised by the confidence emanating from E&P CEOs, suggesting healthier capital markets, higher activity levels, and greater drilling efficiency would lead to considerable production gains in 2010. If the industry is doing more with less, and spending and activity levels are on the rebound, when, if ever, will natural gas supplies contract? We, like many others, expected the dramatic reduction in the rig count would ultimately translate into lower output. However, we haven't yet seen a marked contraction in supply, nor have natural gas prices rebounded to a price that grants the industry an adequate return on capital, in our opinion. Yet many of the largest gas producers look prepared to ramp up production over the next year.
If production declines won't bail out gas prices in 2010, that places greater weight on demand. And after one of the warmest Novembers on record, gas inventories entered winter heating season at record levels. We studied the past 15 winters and concluded that even the harshest winter weather will likely leave us with record spring inventory levels. Industrial demand also remains weak, and until a significant inventory restocking cycle begins in the Gulf Coast chemicals complex, we see weak demand persisting. So near-term demand fundamentals appear soft, and near-term drilling activity is likely to pick up.
It's becoming harder to see how the gas supply overhang will be resolved anytime soon, and with E&P valuations hovering near fair values in aggregate, we'd suggest investors focus attention on select pockets of value within the space. One company where we still saw significant value in the fourth quarter, XTO Energy (XTO) realized it through an agreement to be acquired by ExxonMobil (XOM). We expect that could be one way remaining value-propositions could be realized. However, even if no deals materialize in 2010, we still think companies like Range Resources (RRC), Ultra Petroleum (UPL) and Petrohawk (HK) offer some long-term upside in the E&P space.
The ExxonMobil merger with XTO Energy offers a glimmer of hope despite weak near-term fundamentals for natural gas. If nothing else, the dramatic strategic shift on the part of ExxonMobil--placing a large bet on domestic unconventional gas--is a bet on the future economics of certain shale gas plays. Of course, one may wonder why XTO chose to sell for a price that looks pretty fair (even though it represented a 25% premium to its previous market close). We think ExxonMobil's undervalued stock may offer some upside for existing XTO shareholders, and the attractiveness of the combined entity is compelling. ExxonMobil gains a team well-equipped to acquire and develop shale plays globally, something it and other major integrated firms lack. If ExxonMobil is successful at retaining enough of XTO's team in Fort Worth, the combination appears powerful and unmatched. The combined company will have the deepest pockets in the domestic gas business, the largest domestic supply base, and the ability to import LNG as needed.
Oil and Gas Fundamentals still Divergent in 2010
Like gas, oil and refined products face a considerable inventory overhang, and current production rates continue to trump demand (contributing to still high global inventory levels), making both commodities especially sensitive to near-term demand factors. This is where the similarities between the commodities end, in our opinion. We think oil supply will be challenged to top record output levels in 2007 and 2008, at least for the next three to five years. In an oil supply constrained world, should demand rebound above rates achieved in early 2008, demand destruction would set the price (i.e., oil prices could rise above our estimated marginal cost of new supply of about $80). Given the exploration and delineation success of the domestic E&P companies over the past decade in discovering and proving up new gas-producing regions, natural gas isn't likely to be supply constrained like oil. Given the right price, the industry will bring on supply as the market demands it.
Further, the demand outlooks for oil and gas have diverged. Global oil demand has perked back up, mostly due to a large increase in demand from China combined with stabilization in developed country demand. Because gas is still largely a regionally priced commodity, a still relatively weak U.S. economy is driving persistent softness in domestic gas demand. However, over the longer term we see more upside demand scenarios for natural gas both domestically and globally than we see with oil. Part of this is due to oil supply scarcity and the likely persistent pricing wedge between the two commodities--making gas much cheaper than oil on an energy equivalence basis. We think this positive relative price signal for gas won't go ignored by energy consumers over a longer time frame, even if the ability to switch is limited for the near term.
Benefit of Falling Costs to Recede in 2010
The impact of costs on upstream profit margins is another trend we're considering as we enter 2010. Unlike the start of 2009, when costs had nowhere to go but down, and cost-reduction was a large part of the profit margin improvement we began experiencing in mid-2009 (as oilfield services costs fell 30%-40%), costs now appear set to climb (albeit modestly, in our opinion). This will place greater weight on the commodity price to influence upstream profit margins in 2010, and should prices fall, costs may not offer the same silver lining we experienced in 2009.
Reserves Gains to Remain Muted
Like some investors we've spoken with, we're anticipating a choppy reserves booking outcome at year-end. The spread between oil and gas prices will account for much of this choppiness. Because oil prices have averaged higher than where they stood at year-end 2008 and gas prices have trailed where they stood at year-end 2008, oil-weighted firms enjoy an advantage compared to gas-heavy firms when booking year-end 2009 proved reserves. Some gas-heavy firms may face another wave of negative reserve revisions, given lower gas prices and slashed spending levels.
Despite the shortfalls of the annual reserve reports that upstream oil and gas companies are required to put out, these reports do provide some insight into the quality of the firm's asset base. This year, producers and reserve auditors are dealing with new SEC reserve booking rules. These changes, while designed to provide investors with greater clarity into firms' assets, may actually cause greater confusion due to the additional flexibility provided to producers. Further, the changes could hurt more than they will help for the year-end 2009 reserve reports. Here are some of the things we'll be watching for as the reports come out over the upcoming weeks.
First, we'll be on the lookout for price revisions. Producers should see positive price revisions on the oil side as WTI benchmark prices being used for reserve reports are $57.65/bbl compared with $41/bbl last year. On the natural gas side, negative price revisions are likely as Henry Hub benchmark prices being used are $3.86/mcf versus $5.71/mcf last year. Production costs have dropped dramatically from last year, however, improving economics. This should provide an additional positive boost to oil reserves and limit negative price revisions for natural gas reserves.
The second factor to watch is PUD (proved undeveloped) reserve bookings. Under the new rules, the SEC is allowing a more liberal PUD booking policy--PUD locations can now include indirect offsets as long as reservoir continuity can be shown. This rule change is particularly beneficial to natural gas shale producers who drill horizontally and were previously limited to only two "direct" offset PUD locations. However, time and capital could be limiting factors for many E&P companies. Companies have to show an ability (i.e., through internal funding) to develop those reserves in a reasonable time frame, which most companies interpret as five years or less. We could see meaningful changes to firms' PUD reserves as a result of these changes. This is a concern, as PUDs still require capital to move into the "higher-quality" PDP (proved developed producing) category and companies now have more discretion into their booking decisions, possibly resulting in greater variability across companies.
It's also worth noting that producers can now report probable reserves like their Canadian counterparts, as well as sensitivities to oil and gas prices. However, a number of companies we've spoken with have expressed a reluctance to include probables in their reserve reports given the associated uncertainty. We anticipate an additional layer of skepticism among investors as some producers will disclose this information and others will not.
Valuations Appear Fair
Energy stocks mostly ran in place during the fourth quarter of 2009. For the third consecutive quarter, E&P companies' stocks matched or outpaced the prices of assets in recent deals (based on comparing companies' enterprise value/reserves versus dollars spent per mcf of reserves in the marketplace). We've also seen debt yields continue to fall across the energy sector. Companies are taking advantage of healthy debt and equity markets to improve their liquidity, do deals, and fund greater levels of spending. All told, we view these marketplace observations as further evidence that energy stocks remain fairly valued as a group. We'd need to see sustained oil and gas price strength or further multiples improvement to justify significant stock price gains from here, in our opinion.
As a group, energy is very close to fairly valued, much like it was toward the end of the third quarter and during the fourth quarter. Recent valuations contrast sharply with where we stood in the fourth quarter of 2008 and the first quarter of 2009. Higher oil prices, improving sentiment about the future of gas prices, and healthier credit markets have combined to drive the rally in the middle of 2009.
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