Outlook Of The Oil And Gas Sectors

The current market turmoil has been particularly brutal in the oil space, with all sub-sectors getting down to levels not seen in years. While expectations of softening oil demand over the coming quarters and broad credit-market concerns have been the primary reasons for the sector’s woes, the sell off has by all measures been overdone.

This indiscriminate sell off has made the risk-reward trade off of a number of sub sectors very compelling, in our view. Our best ideas are in the integrated, oilfield service, and offshore drilling sub-sectors.

• While downside risks still remain, particularly if the global economic weakness turns out to be more protracted than currently anticipated, oil prices are expected to consolidate around current levels. We expect crude oil prices to bottom around $70 a barrel.
• We are strong believers in the secular underpinnings of the oil cycle — the current downturn is just a pause in a long secular cycle that still has plenty of room to go.
• The large-cap integrateds (Exxon, Chevron) remain the best positioned given their energy conglomerate business structures, stellar balance sheets, substantial free cash flows, and growing dividends.
• Growing domestic production and moderating demand, particularly from industrial consumers, is expected to weigh on natural gas prices for the remainder of this year and next.
• The tentative natural gas price outlook, which preceded the credit-market related turmoil of the past month, is expected to cap the upside in the exploration and production (E&P) space. This group also has credit market exposure.
• The underlying business fundamentals of integrated oilfield service companies (Halliburton, Baker Hughes and deepwater-capable drilling contractors (Transocean, Diamond Offshore) still remain robust. Oil prices will need to drop even further and then stay there to materially impact their operating outlook.

This outlook reflects credit markets getting back to normal over the coming days, a three/four quarter period of negative economic growth in the OECD markets, and decelerated growth in the emerging world. An outcome worse than this outlook represents a clear downside risk.

We believe that the large-cap integrated oil companies offer compelling values. Our best picks remain Exxon (XOM), Chevron (CVX) and ConocoPhillips (COP). These stocks are currently trading at multi-year lows, exceptionally cheap both in relative as well as absolute terms, and offer more upside potential than downside risk. These companies have fortress balance sheets (Exxon is AAA rated and has more cash on its balance sheet than debt), generate strong cash flows, and pay out growing dividends.

The global integrated oilfield service names are also very attractive. Our preferred names in this space are Halliburton (HAL), Baker Hughes (BHI), Smith International (SII) and National Oilwell Varco (NOV).

Another group hit hard by the recent turmoil is the offshore drillers, particularly those capable of drilling in the deepwaters. Our preferred deepwater drillers remain Transocean (RIG) and Diamond (DO). Another offshore driller with an underappreciated deepwater drilling portfolio is Pride (PDE).

All of these have been hit hard by the combination of commodity-price weakness and credit market turmoil. But these operators do not require peak-cycle commodity prices to generate stellar results and have limited or no credit-market exposure.

Posted in Categories: Contributor, Energy, External Research, Stocks, USA.

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