I. Executive Summary
Noble Energy, Inc. (NYSE:NBL) is a relatively small independent exploration and production company based out of Houston. The Company operates in 5 core operations; the DJ Basin, Marcellus Shale, Gulf of Mexico, Eastern Mediterranean, and West Africa. The Company has historically produced mainly gas but has recently rebalanced its production, along with its portfolio of operations, to be more diversified.
The economy NBL faces is a mix. A good portion of their operations have been affected by slow U.S. growth and even worse Europe exposure. But Noble's operations in Africa and Israel were minimally affected by this.
The Company is an energy firm so within the market it is considered aggressive. The stock has a high beta and moves sensitively to oil and gas prices like most energy stocks. Within the industry, it is about average in size and scope.
Like all other E&Ps, the top line is sensitive to commodity prices. Based on EIA projections, I expect gas to average $3.49 MMcf, WTI average $88 per barrel, and Brent to average $103 per barrel.
Compared to its peers, the Company is fundamentally out of the picture. In some metrics, the estimated growth makes up for the price, but overall NBL lags in these metrics.
The Board is filled with individuals experienced in oil and gas, but not necessarily in Noble. The active and large stock-based compensation plan adequately aligns shareholder and management interests.
Together with my price target of $97.12 and fundamental analysis, I have concluded that Noble Energy, Inc. is a HOLD.
II. Company Description
Noble Energy, Inc., an independent energy company, engages in the acquisition, exploration, development, production, and marketing of crude oil, natural gas, and natural gas liquids in the DJ Basin, Marcellus Shale, deepwater Gulf of Mexico, offshore Eastern Mediterranean, and offshore West Africa. Its principal projects comprise onshore US projects located in the DJ Basin and Marcellus Shale; Galapagos project located in the deepwater Gulf of Mexico; Tamar project located in the offshore Israel; and Aseng and Alen projects located in the offshore Equatorial Guinea. As of December 31, 2011, Noble Energy, Inc. had 1.2 billion barrels oil equivalent reserves. The company was founded in 1932 and is headquartered in Houston, Texas.
III. Economic Outlook
The global economy is not only sluggish but in danger of deep recession. The OECD cites a drop in confidence as the key driver. In their recent economic outlook they, like the IMF, suggest that policy responses have both been weak and ill-timed.
The IMF data above shows the global economy moving relatively in sync, with the exception of Europe. Their October issue of the World Economic Outlook highlights an important theme; emerging economies have been outperforming advanced economies in terms of GDP and time spent in expansion. The previous decade was the first 10 year period that emerging economies were in recession less than advanced economies, like the U.S. and Europe, and recovered faster too. The IMF believes this trend will continue until advanced economies' policy makers consistently use appropriate actions.
Gross domestic product measures are very important and generally used as proxy for oil demand. As growth accelerates, so does demand for energy to fuel that growth.
Consumer spending is the largest part of GDP measures. Spending generally indicates how much consumers will spend on goods like oil. The EIA's estimate of real disposable income growth is 2.3% annually for the next until 2040.
Other important economic measures for energy include housing starts and vehicle sales. Housing starts are critical for gas demand. Not only do positive signs in the housing market indicate a healthier economy, but residential consumption represents a substantial portion of gas demand. Vehicle sales are a direct measure of oil demand; simply put, the more cars on the road, the more gasoline being bought.
Finally, commercial floor space is a good indicator of industrial and commercial gas demand. Businesses that need heating often do so with natural gas. Data from the EIA indicates that natural gas heading for commercial use will increase annually by 0.4% through 2040. The majority of this growth will be new additions.
Year to date, the S&P 500 has performed about 200 basis points better than its well-known average of about 9%. The most significant mover in 2012's market was QE3, and even the anticipation of QE3. The Fed officially announced the measure on September 13, 2012, that included $40 billion of mortgage backed security purchases per month. Including the low rate policy, these actions have almost no time table and were regarded as very aggressive. Despite concerns of dollar devaluation, inflation, and government credit problems, the market received it well.
IV. Energy Sector Outlook
The energy sector of the S&P 500 is divided into 5 major industries. Majors and super-majors have the largest market cap and are the most diversified. This group is led by giant Exxon Mobil and Chevron. They do it all; exploring, drilling, producing, transporting and refining.
Exploration and production (E&Ps) firms are smaller and are solely focused on finding and producing oil and gas (also known as upstream). Some specialize in either commodity and others do both equally. Typically, they comprise of the exploration teams and lifting teams and will need to hire drillers and service companies.
The equipment and service industry provides dozens of different services and sells equipment to E&Ps or majors. These companies are typically smaller and might specialize in a certain type of equipment with a specific use.
Drillers are usually entirely focused on drilling contracts but sometimes might do seismic work or their own exploration and most drillers specialize in a type of geology; onshore unconventional, onshore conventional, or offshore.
Lastly, there are refiners (also known as downstream). These companies are usually small and are in a very competitive market which has drove margins down. Refiners are considered defensive because they offer good dividends and will outperform when oil is falling because it is their input.
The sector as a whole is fundamentally cheap. The P/E ratio is 12.3, and the P/B ratio is 1.85. Although it is trading at a discount to the market, it has underperformed year to date.
I believe this is due to two reasons. First, there is a concern of legislative risk. Every company in the sector will suffer from legislative measures that limit production to any extent. Secondly, I think the current market is avoiding volatility. Energy is an offensive sector that will benefit from a strong bull market.
Generally, activity in the energy sector is picking up. There is more exploring, drilling, producing, and refining being done today than 5 years ago and as a result there is more being spent as cap-ex. The direction of activity has changed, too. As a result of previous decades of exploration, deepwater activity is rising because the globe is running out of basins to drill. The future of this sector is deepwater. Until a viable alternative energy has been invented, oil and gas will be king because of their energy efficiencies.
V. Industry Outlook
The upstream industry is unique in that there are many different sizes of firms and business models vary significantly. The common thread is the price of oil and gas because the top line is very sensitive.
Since the explosion of unconventional plays and the over-production of gas, E&Ps of any significant size have been forced to change strategies and target more liquids. Gas-heavy firms suffered a beating in the last two years from this and the firms already positioned towards oil have reaped the benefits. For some, including NBL, it was a scramble to divest previous core assets for oil rich plays. The scramble is over, however. Companies that previously were overwhelmingly gas producers are now starting to expand liquid production and oil reserves. The market isn't looking for investments in new fields anymore; production and reserve growth is much more valued.
This has been the reason for the jump in activity in liquid-rich basins like North Dakota's Bakken and Texas' Eagle Ford. Both produce high grade oil accompanied by wet gas so they are highly valued fields. Again, like the fortunate firms that already had infrastructure in oil, those that had positions in basins like these have gained at others' loss.
Lastly, the global scale of production is shifting towards North America. Recently, the IEA projected that the U.S. would become the world's largest oil producer by 2020 and a net oil exporter by 2030. This not only has huge ramifications for production and investment but it also will shift the balance of power. According to the forecasts of IHS CERA, cap-ex will reach $274 billion by the end of the year and will reach $528 billion by 2016. And in terms of drilling activity, North America represents 50% of global activity.
VI. Oil and Gas Outlook
As an E&P, the Company's lifeblood is the price of energy sector commodities. Both oil and natural gas are extremely volatile in today's conditions. Major factors influencing the price of oil and gas are new drilling technologies, risk premiums, supply glut discounts, legislative actions, supply from production, and demand from consumption.
Most of NBL's operations are domestic. The Company is very active in the Denver-Julesburg Basin (DJ basin) and in the Gulf of Mexico. North America has been the biggest beneficiary of the new drilling technology, namely fracking and horizontal drilling. Simply put, these technologies drastically increase the viability of fields and the volume produced. Basins that need fracking or horizontal drilling are termed "unconventional plays." For both commodities, production volumes jumped and increased supply in the near term and long term.
Increasing activity in unconventional plays has had a profound effect on the supply, aside from increased volumes. Part of the extreme volatility in these commodities is attributed to the nature of these plays; because drillers can get to the play faster and complete the well faster, E&Ps are able to commit to a project with a shorter runway. When the time to first completion is shorter, firms can get in and out of a play faster and thus create volatility in the commodity markets.
These commodities are also heavily influenced by certain premiums; most notably the risk premium in oil. The recent disconnect between WTI and Brent benchmarks illustrate this effect. Conflict in the Middle East, where much of the world's oil is produced and transported, has led to a very high Brent price, while the U.S. WTI benchmark is nearly unaffected. Historically, WTI trades higher than Brent because it is of higher grade. The risk premium makes oil prices very hard to predict; both benchmarks are highly sensitive to news from the Middle East.
More specific to domestic production, both oil and gas prices have suffered from a "supply glut." Because production in the U.S. has grown exponentially, infrastructure to hold, transport, and sell the new supply has been lagging. Transportation has been a huge problem for the Bakken basin. The area lacks enough pipelines to transport the particularly sweet grade oil so it isn't selling for the price it would otherwise. The major pricing point in the U.S. is Cushing, Oklahoma. Cushing is currently oversupplied too and is having trouble even storing all the oil coming in. The result is a lower WTI price. The infrastructure needed will be built but it will take some time. Producers need to keep this in mind when they plan projects.
Oil and gas will continually be under scrutiny from environmental activist pressure and subsequently are vulnerable to legislative risk, mostly domestic. There has been controversy on fracking methods and their effect on underground water. So far, companies have done a decent job being accountable and proactive about fracking. The studies that have been conducted haven't reached the conclusion that fracking is inherently dangerous because, as of now, the seed of doubt is whether fracking is dangerous when done wrong or whether it can cause problems under any circumstances. Any change in law on a federal level will have huge ramifications for our production in oil and gas. Our country will be at a crossroads between plentiful energy and environmental safety. I believe our decision will be completely dependent on our state of economy at the time. Most recently, the U.S. Energy Department has come to the conclusion that exporting some of our natural gas supply is good for the economy. This has massive consequences for the domestic price of gas. Even though our exports aren't likely to be very big, it will raise our price significantly. Any further decision on this matter will continue to affect the price of gas. Lastly, the permit issuance needed to drill in the Gulf of Mexico has been slow since the BP oil spill. This illustrates the reluctance that the Obama Administration has towards exploration in the area. Any problems coming from drillers in the Gulf of Mexico will affect the production coming from the area.
As mentioned before, the supply in the U.S. of both commodities are very high. Internationally, the story is a little different. The Organization of the Petroleum Exporting Countries (OPEC) is the big player in the global energy market as they produce about 40% of the world's oil supply. Assumptions of OPEC production are priced into the price of oil consistently. OPEC typically has a quota that member countries are supposed to abide by, but they rarely continue to stay at their targets. Thus, production from them is hard to determine. The Energy Information Administration estimates that OPEC will produce 31.08 mmbbl/d in 2012 and 30.59 mmbbl/d of oil in 2013. Although compliance and consistency with these numbers can't be expected, these are assumed in EIA's future oil prices.
The main determinant of future OPEC supply is the response to the current sanctions on Iran's oil. The sanctions have allowed other members pick up the slack in demand. This, in turn, reduces spare capacity of OPEC production.
OPEC's spare capacity has shown an inverse relationship to the price of Brent in recent years so if Iraq's production isn't picked up by other members oil's price will likely go up.
The EIA expects non-OPEC liquid supply to have increased slightly to 52.41 mmbbl/d in 2012 and to continue to increase to 53.67 mmbbl/d in 2013. This increase is mainly driven by the aforementioned unconventional activity in North America.
As mentioned before, domestic gas production is very high. The EIA expects production to have flattened out in the latter half of 2012 and to stay steady through 2013. With the boom in gas production, and the subsequent plummet of prices, came a large reduction in gas-targeted drilling.
The chart below shows that even though rigs are now targeting oil, the U.S. gas production is essentially flat. When E&Ps like Noble drill for gas, they inevitably produce gas as well, and enough gas to keep production flat. This is evidence that the U.S. will have enough supply to support demand for a long time.
International production numbers are unavailable from the International Energy Agency but some assumptions can be made. Most countries outside of the North America haven't been able to replicate the unconventional drilling success that the U.S. and Canada have. This is because of a combination of different and unknown geology, lack of expertise and lack of shale reserves. Global production is estimated to be similar to domestic production; about flat.
. Global oil demand is highly correlated with economic growth. Demand is therefore contingent on swift actions with regard to the U.S. fiscal cliff and Europe's debt woes, but is generally slowing in growth along with GDP projections. The EIA expects world consumption growth in 2012 to be about 0.7 mmbbl/d and 0.9 mmbbl/d in 2013. The slowdown in consumption growth will be caused by OECD countries declining consumption, specifically European countries.
The total U.S. liquids consumption is expected to only increase from 18.66 mmbbl/d to 18.77 mmbbl/d in 2013 if we get past the fiscal cliff. The EIA cites slow growth in the driving-age population, retirement of baby-boomers, and improved fuel efficiencies in automobiles as reasons that consumption will lag behind GDP.
Gas consumption in the U.S. is almost exclusively demand from utilities; the balance between electric power use and residential/commercial heating use ends up being the demand. The EIA projects that electric power usage will have picked up in 2012 to a high average 25.4 Bcf/d and decrease to 22.52 Bcf/d in 2013. Heating usage is expected to pick up substantially because of the low price; together the total consumption is expected to just slightly decrease from 69.75 Bcf/d to 69.28 Bcf/d in 2013. The decrease in electric usage is likely attributed towards the bottoming of prices; $3 per Bcf is generally regarded as the point at which most utilities see gas as the best option. Now that gas is above that, utilities that don't specialize in gas will likely stay away from gas.
International gas demand is hard to determine as well. Because of lacking growth in OECD countries and slowing growth in emerging markets, I will assume that gas demand growth is similar to oil consumption growth.
I agree with the EIA estimates and have used them for my projections. The EIA has done a great job analyzing the short and medium term factors to come up with these final price projections. Brent will average $103 in 2013, West Texas Intermediate will average $88 in 2013, and importantly the spread between the two is decreasing, according to EIA estimates.
The EIA also believes that U.S. natural gas will average $3.49 per MMBtu in 2013. This is on the low range of estimates by analysts but I agree with it. Supply is not only very high, but very sensitive to production in oil. I believe that if gas does rise on demand, it will fall shortly after the rig count, the leading indicator for production, rises.
VII. NBL Operational Outlook
The Company has very unique and exciting operations that have attracted investors already. They keep their focus on 5 core operations; DJ Basin, Marcellus, Gulf of Mexico, Eastern Mediterranean, and West Africa.
The DJ Basin is an average sized basin in the heart of the U.S., almost centered on Denver, CO. This operation is receiving the bulk of 2013 cap-ex. Recent operational updates from the Company indicate activity, especially horizontal activity, is up substantially; NBL expects to achieve 300 horizontal wells in the area. Aside from above average expected production; the DJ Basin has offered the company an opportunity to expand in un-ventured parts of continental U.S as the Company is currently testing wells in northeast Nevada.
The Marcellus shale play is the most profitable domestic gas play. Noble entered the area in a joint venture with Consol Energy (NYSE:CNX). Under the agreement, NBL will pay a carry of CNX's drilling and completion costs that is capped at $400 million per year for 8 years. Despite a covenant that prevents either from drilling for gas when spot prices have been below $4.00 per MMcf for 3 months, NBL has been drilling for wet gas and very successfully. They expect 85 wells lifting wet gas in 2013 and are getting great pricing for that wet gas.
The Company was the first chosen to receive a permit for Gulf of Mexico activity after the moratorium passed. I see this as a confirmation of their "top quartile" quality safety record. Their operations in the Gulf include a Galapagos development project, Ticonderoga, and the newly spud Gunflint and Big Bend areas.
Noble's claim to fame is their operations in the Eastern Mediterranean, namely offshore Israel. The area only accounted for 14% of 2011 sales but easily has the most growth potential of any operation in their portfolio. Israel recently suffered from being cut off Egypt's energy sales and was starving for gas for some time. That has subsided for Israel, but their energy security depends on Noble's development of the Mari-B, Tamar and Leviathan fields. The Company leads the group that just signed gas deals worth about $4 billion with Israel. According to the Company, Tamar is scheduled to start-up in April, 2013.
Lastly, the Company has a variety of operations in Africa including minority active investments in a methanol plant and a liquefied petroleum processing plant. The 3 largest, Alen, Anseng, and Alba have been well positioned by the company. The Anseng project is a crude play that where they recently purchased a floating production storage and offloading ship (FPSO). The purpose of an FPSO is to store, process and transport product very efficiently. The Alen project, which is mostly gas, is also being piped to the FPSO increasing that well's efficiency too. The Alba field is a large natural gas field where they have major investments in the previously mentioned plants.
The Company's historical production is overwhelmingly gas. Recent divestitures have freed up capital to target domestic crude in the DJ basin. Outside of the DJ basin and GOM, the Company's only other major oil play is the offshore African projects which are only half the production of total U.S. operations. As for gas, the U.S. contributes the most MMcf/d, next to Africa and then Israel. As a percentage of revenue, the investments in plants are almost negligible.
The Company's peers include other average-sized E&Ps. I consider the most direct competitors to be Anadarko Petroleum (NYSE:APC), Apache Corporation (NYSE:APA), and Devon Energy (NYSE:DVN), based on volumes, size, and areas of operation.
Fundamentally, NBL is the most expensive. The P/E, P/S, and P/B are all significantly higher than the Company's most direct peers and industry averages. Noble also lacks in margins and has for the past 5 years, but this is expected considering the exotic operations they are in. The Company has on-par dividend and debt. Together, these basic metrics indicate that the market believes NBL requires a premium to competitors.
With the exception of APA, which is a much older and bigger, NBL wins on cash flow. I am projecting negative free cash flow for 2012 along with most analysts, but the growth from this year's cap-ex will reap future benefits for shareholders.
Overall, the Company is in the process of serious growth so on paper it seems like a bad investment. A look further will show how the Company commands the price it currently trades at.
IX. Corporate Governance
By all measures, NBL's corporate governance risk is low. Charles Davidson leads the board and has been the CEO for 12 years after decades of experience at Vastar. Most of the board members are former executives of Vastar, which is now a part of BP plc. Both the COO and CFO have only 3 years' experience in executive positions but have been with the company for about 10 years each.
The Company actively pays their executive with a stock-based compensation but doesn't have a scheduled plan. Past 10-Ks indicate that the stock-based compensation doesn't correlate with stock price or performance. The management does, however, have a lot of their pay in stock. In total, the company has over 6 million shares outstanding from their pay, and 4.5 million of these shares are exercisable. Further, the weighted-average length of term left on those options is short; a little over 5 years. Insider transactions are small and insignificant, too.
NBL has an averagely experienced management team and there is no reason to believe the team isn't qualified for their positions. Their compensation isn't a concern either. I believe shareholder's interests and management's interest have been aligned with each other. The performance of the stock has been about in line with the SPDR since the election of Davidson.
Historically, the Company has gone through times of huge premiums to the market and huge discounts. Of the last 10 years, NBL has spent more time trading at a discount to the market. I attribute this, and its large price tag, solely to current operations and their growth. At a 37 P/E, it has a 0.8 PEG ratio; lower than all direct competitors and on-par with industry average. Investors will be paying a premium today for a year or two of negative free cash flow followed by superior growth.
NBL has many strengths. It has proved to be flexible when, after several stagnant years, make a swift switch of focus from mostly gas to a balance when the environment encouraged liquid production. It is the operator on the majority of its projects and joint ventures. Very few companies achieve this and it can only be the result of recognized expertise.
I really like the recent divestitures and increased focus on core operations. Management recognized the potential in 5 very diverse projects and executed a plan that will pay off for investors because Africa and Eastern Mediterranean are areas of large growth according to the data from the IMF.
Lastly, as I have described before, pricing makes or breaks a company. Noble has achieved great pricing on their production, specifically in Africa. The total percent of crude priced at Brent or Louisiana Light and Sweet (LLS) is above 50%; and that portion is growing.
As far as risks, Noble is clear of most risks the rest of the energy sector might face. It isn't, however, poised to take advantage of key trends that others might. The DJ Basin offers unconventional exposure, but not to the degree NBL's competitors have. The only other play they have with the potential of unconventional-like volumes in the Marcellus, but their covenant prevents them from drilling. As I projected, natural gas will not reach $4 MMcf in 2013, and definitely won't stay above $4 for 3 consecutive months.
My projections predict essentially the same story as the last 2 years. On an energy equivalent basis, gas will lag behind because the domestic supply will outweigh reasonable demand growth. Until the U.S. slowly uses the gas we have, or our use is increased beyond heating and chemicals, we will have relatively low gas prices.
The stock had a run after its recent Q3 beat. The Company handedly beat estimates on better-than-expected production and a high net income in a bad earnings season. NBL stood out, and for good reason; it's a great company. The fundamentals seriously lack both the industry and direct peers though. This indicates that a buy today means paying partly for hype. Through my discounted cash flow, I found a $97.12 price target. I believe a higher price target would probably be the result of underestimation of their costs or over-optimistic commodity price projections. Looking back at previous periods with increased exploration activity and cap-ex reveals serious general and administrative expense and COGS problems. Both of these costs make up a significant portion of expenses and more importantly are very sensitive to exploration activity. NBL's current exploration is aggressive and fueling growth but will cost the bottom line and cash flows. The sensitivity of domestic supply to the total rig count leads me to believe that any big increase in the price of gas will be quickly diminished by companies starting to target gas again. The unconventional plays gave companies like NBL huge reserves but also guaranteed low prices for the near term.
The combination of my fundamental analysis and the discounted cash flow analysis lead me to put a HOLD recommendation on Noble Energy (NBL).
**Written Dec. 4, 2012
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.