What happened to Oil?
Where do we go from here?
Up but maybe not in a straight line!
As we have said for a while now we are bullish on oil prices and bearish on natural gas prices. After our companies first quarter earnings reports we have fine tuned our models and adjusted our commodity price assumptions. We have raised our oil price assumption to $84 for 2010 (+$4) and to $86 for 2011 (+$1). We have lowered our natural gas price assumption to $4.85 for 2010 and to $5.50 for 2011.
Why have oil prices fallen so hard in the past two weeks?
We are not sure but would cite four factors we believe have lead to the decline. The first being Greece, the general pressure on the Euro zone, and the belief that those factors could lead to another global slowdown and another step down in demand. The second being the strong US dollar that over the past few years has shown a strong inverse correlation with oil prices hence the dollar’s strength is oil’s weakness. The third factor being April OECD inventory levels, which showed a build of about 45 million barrels, which is about two times the normal April inventory, build. Finally the fourth being the IEA coming out with their monthly supply and demand analysis of the oil markets globally and cut their estimate of 2010 demand by 200,000 barrels per day to 86.4 million.
As we mentioned in the April 11 energy macro report, we were frankly surprised that oil was trading at $86 based on the supply and demand trends we were witnessing in the market. We expected to see oil trade to these levels during the third and fourth quarters of this year. We still envision oil averaging over $86 in the back half of the year.
When we look at our supply and demand models, consistent with our March energy macro report, our demand number remains at 86.5 million barrels per day with the US up by 200,00 barrels, Europe down, and China up about 6%. As it stands today those estimates are reasonable as the US number is close to spot on and China (though the data is hard to get) is running ahead of our forecast. Even if Europe is down more than we anticipate as long as they don’t drag the world down with them our numbers appear solid. We don’t know when oil prices will stop falling however we think we are much closer to a bottom and don’t feel a collapse in imminent.
We are slightly more constructive on natural gas even as we lower our price deck.
We may be reading too much into one data point but the injection number last week was constructive. We think this week’s injection will be below both last year and the five-year average. We think there is finally some evidence of gas drilling rigs being laid down (as of last Friday there were 951 versus 959 from our prior piece), industrial demand remaining strong, and some coal switching taking place. That being said we will exit injection season around November 1 with over 3.9 TCF of gas in storage, which would be an all time record. If we get help from weather, industrial demand, fuel switching, and a drilling slowdown possibly we could come in at 3.75 TCF but either way storage will be close to capacity and this should keep natural gas prices relatively weak through 2011. We do think the $3.75 price we saw could mark the bottom for the near term.
Where are we focusing our efforts?
We continue to like the oil centric names that we follow that can demonstrate good production growth, reserve replacement characteristics, and good finding costs. We really believe the Bakken oil play is the real deal and like the companies exposed to it - especially the smaller ones, where it is very impactful to both their production and valuation. These stocks have sold off very hard over the past week and we think excellent opportunities abound in these names. We also think the gas names have lagged until this past week and that some opportunities exist. Again we would look for companies with strong assets, a low cost structure, a decent balance sheet, and reasonable production growth.
Two Ratings changes
CLR goes to buy with their excellent Bakken exposure and a $58 price target.
ARD goes to hold as they are merging with SD and we wouldn’t want to take that paper. Target $35
We believe oil prices will average $84 and natural gas $4.85 for 2010 over a 16-1 ratio against the BTU equivalent of 6-1 and the historical range between 8 and 10 to 1.
We still favor oily names but would argue for selected exposure to gassy names.
Our favorites are:
BEXP Target $30. Great growth, wonderful acreage position, and a reasonable valuation.
GEOI Target $23. Good growth, good management, and an excellent valuation.
BRY Target $43. Solid growth, low risk execution, and a cheap valuation.
CLR Target $58. Great Bakken position, good growth, and a conservative management team.
CXO Target $68. Low risk strategy and good growth.
KOG Target $5. More risk but good Bakken position and good balance sheet to achieve drilling program.
NOG Target $23. Good growth and good Bakken exposure.
GTE Target $7. Nice Columbian position with exploration upside.
UPL Target $62. Gassy but undervalued with good production growth and a low cost operator.
BBG Target $45. Gassy but with good hedge position and low cost structure.
STR Target $60. Diversified and defensive with low cost and great management.
We like the service names as well:
SLB Target $84. Best in class service name over sold due to GOM disaster.
BHI Target $61. Very inexpensive with synergies from merger not well understood.
HAL Target $44. Very cheap due to disaster. There is headline risk here but plenty of upside.
CLB Target $170. Executing best in class with superior returns.
CAM Target $55. Inexpensive with GOM disaster taint but in the final results we don’t think they share much blame. But there is headline risk to owning.
Disclosure: Long BEXP, GEOI