Exploration and Production Second Quarter Review and Outlook
Thursday, July 9, 2020
Energy Industry Report
Exploration and Production Second Quarter Review and Outlook
Michael Heim, CFA, Senior Research Analyst, Noble Capital Markets, Inc.
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- Oil and Gas Prices rebounds after hitting record lows. Oil spot prices even went negative after COVID- 19 killed demand and Saudi Arabia and Russia began a price war. Current prices rebounded to finish the quarter near $40. Natural gas prices fell to $1.58, a level not seen since December 1998, before rising to finish the quarter at $1.67.
- Energy stocks reported a strong quarter rising 33%. The strength largely reflects a rebound in the overall market. The XLE Energy Index remains down 40% year to date.
- The outlook has improved but remains dark given COVID-19 reemergence concerns and a shaky OPEC truce. Low-cost producers will generate positive cash flow if oil remains above $40, but high-cost producers are not out of the woods yet.
- We recommend investors remain cautious and focus on low-cost producers with limited debt.
When you hit bottom, there is nowhere to go but up. Oil prices crashed in April following the spread of COVID-19 and a price war between Saudi Arabia and Russia. Spot prices even traded as low as negative $37 per barrel. The concept of investors paying another investor to take oil off their hands is perhaps bizarre, explainable when viewed only as a short-term issue of speculators being caught with contracts in their hands and nowhere to dump the contracts with storage fields full. Nevertheless, longer-term contracts followed spot prices downward, if not into the negative range. Oil future contracts going out a month or two fell from prices in the thirties per barrel into prices around $20 per barrel. As expected, the sharp drop in pricing lead to an immediate response. Domestic producers all but eliminated new drilling and Saudi Arabia, Russia and other allies made up (kind of) and agreed to cut supply by 10% through the end of July. Whether the cuts last remains to be seen as there are already reports that several OPEC members are not adhering to reductions. However, current WTI and Brent oil prices, both near $40 per barrel, provide energy companies a lifeline they didn’t have three months ago.
Natural Gas prices fell, albeit not as much as oil prices. Spot prices began the quarter around $1.75 per thousand cubic feet (mcf) and fell as low as $1.38 per mcf, the lowest level in nominal dollars since December 1998. Inventories remain high following a mild winter and demand remains low due to the shut down of the economy. Liquified Natural Gas (LNG) terminals are reporting a decrease in gas exports and the pace of development of new projects is slipping. Production levels are holding steady even as natural gas rig count has decreased.
Energy stocks, as measured by the XLE Energy Index, rose 33% in the second quarter. The strong performance generally tracked the rise in oil prices with most of the gain coming at the end of the quarter. Truth be told, however, the gain is primarily due to an improvement in the overall market and not a rise in energy prices. The S&P 500 Composite index rose 26% during the quarter. Both indices were down sharply in the first quarter and the strong performance in the second quarter merely reflects a rebound from the first quarter. Year to date, the XLE is still down some 40%.
The return to oil prices in the forties was welcome news to leveraged energy companies facing negative cash flow and an inability to meet financial obligations. At prices in the forties, companies with a low-cost basis should generate positive cash flow. That said, marginal wells will most likely not be drilled. Of particular interest is whether or not these companies will lock in modest gains by hedging out production. Or, will they view these returns as inadequate to compensate owners for the risks they are taking and continue to roll the dice on the hopes of higher prices? In the end, the outlook for energy prices and energy company stocks has not changed. The outlook will depend on the pace of recovery of global economic conditions and the will of OPEC plus to hold the line on pricing.
We believe investors should continue to be wary regarding energy stocks. Investors would be wise to focus energy investment towards companies with little to no debt. A large hedge position may provide a lifeline. Low lifting costs per barrel remain important. A supportive ownership group with a long investment timeframe is also important. That said, there are compelling values within the group now that individual stock prices have fallen. We continue to believe energy prices will eventually return to higher levels with a return to more normal economic conditions and a supply response by domestic producers. We have adjusted our long-term oil and gas price assumption to $50/bbl and $2.50/mcf respectively, although we believe it may be several years before we reach those levels. Our individual stock net asset values and price targets are based off of our long-term energy price assumptions.
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Senior Equity Analyst focusing on Basic Materials & Mining. 20 years of experience in equity research. BA in Business Administration from Westminster College. MBA with a Finance concentration from the University of Missouri. MA in International Affairs from Washington University in St. Louis.
Named WSJ 'Best on the Street' Analyst and Forbes/StarMine's "Best Brokerage Analyst.”
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Report ID: 11365