Equity Research Report Release
Thursday, April 2, 2020
Energy Industry Report
Energy Sector Review and Outlook
Michael Heim, CFA, Senior Research Analyst, Noble Capital Markets, Inc.
Refer to end of report for Analyst Certification & Disclosures
- Energy investors looking for relief in 2020 drilled a dry hole. The dual impact of the Coronavirus and a Saudi Arabia oil price war sent oil prices crashing down and with them, energy stocks. The XLE Energy Index fell 52% in the quarter ending March 31, far outpacing a 22% decline for the S&P 500 Index.
- Energy prices drop even further. West Texas Intermediate (WTI) oil prices for the May 2020 futures contract began the year at $61.18 per barrel and finished the quarter at $20.13 per barrel, down 67%. Henry Hub natural gas prices for the May 2020 futures contract fared a bit better dropping 25% to a level of $1.60 per thousand cubic feet (mcf).
- A supply response is coming but it might not be in time to save small energy companies. Needless to say, oil prices in the twenties is disastrous for domestic energy companies. Many companies claim to be able to break even at oil prices in the forties. Without an improvement in oil prices, many U.S. producers could be headed towards bankruptcy at a rate similar to what happened in 2016.
- Be selective but values are out there. We believe investors should continue to be wary regarding energy stocks and focus on companies with good balance sheets. 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.
Exploration and Production: 2020-1Q Review and Outlook
Energy investors looking for relief in 2020 drilled a dry hole. The dual impact of the Coronavirus and a Saudi Arabia oil price war sent oil prices crashing down and with them, energy stocks. The XLE Energy Index fell 52% in the quarter ending March 31, far outpacing a 22% decline for the S&P 500 Index. West Texas Intermediate (WTI) oil prices for the May 2020 futures contract began the year at $61.18 per barrel and finished the quarter at $20.13 per barrel, down 67%. Henry Hub natural gas prices for the May 2020 futures contract fared a bit better dropping 25% to a level of $1.60 per thousand cubic feet (mcf).
The Coronavirus and its resulting global economic slowdown will undoubtedly lead to a decrease in the demand for oil. Highways are empty, airlines are shutting down and factories are closing. Estimates for the impact range from a decline of 2.5 million barrels of oil per day (MBOE/d) to 12 MBOE/d. The upper end of the range would represent a 12% reduction in demand from pre-virus levels near 80 MBOE/d. This is demand that will be gone forever, not just pushed back into future quarters.
Complicating issues is the fact that Saudi Arabia and Russia are flooding the market with excess oil. On March 6th, the bottom fell out when OPEC and Russia failed to agree to a production cut, and Saudi Arabia signaled it might ramp up production. WTI prices fell $10.15 per barrel, or 24.59% to a level near $30 per barrel. The decline marked the second biggest one-day decline on record and the largest since 1991. Since March 6th, oil prices have continued to slide as the Energy Information Administration (EIA) reports a growing stock of crude oil in storage.
Needless to say, oil prices in the twenties is disastrous for domestic energy companies. Many companies claim to be able to break even at oil prices in the forties. However, none claim to be able to do so at prices in the twenties. We have said in the past that U.S. producers have become the producers on margin. They will be the first to react to changes in oil prices by adjusting drilling. Already, many companies have announced that they have cancelled their drilling programs.
The United States has grown to become the largest producer of oil at 11 MBOE/d. It has done so through horizontal drilling and fracking that accelerates initial production rates. These techniques, however, also lead to sharper declines if new wells are not drilled. Without new drilling, U.S. production could quickly slip back towards the 6 MBOE/day level of just ten years ago.
What is most disturbing about the recent drop in oil prices is that the market does not view the drop as temporary. Looking at future month contracts, prices rise very slowly. That means that the market believes Saudi Arabia is not bluffing about raising production and that OPEC and Russia wonâ€™t reach an agreement to cut production. It also means the market believes the impact of the Coronavirus may continue well into the future. It also means the market does not believe that there will be a quick supply response by U.S. producers.
U.S. producers can withstand temporary dips into the forties, thirties or even twenties. Many companies hedged part of their production when oil prices rose last year. Two years of oil prices below $40 would be another story. Companies have operating and financial costs to consider. Companies that have tapped their lines of credit could see that credit reduced or eliminated leaving management with few options now that energy stock prices have fallen. Without an improvement in oil prices, many U.S. producers could be headed towards bankruptcy at a rate similar to what happened in 2016.
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 time frame 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