Movers and SHAKERS
Wednesday, January 8, 2020
Energy Industry Report
Exploration and Production: 2019 Review and Outlook
Michael Heim, CFA, Senior Research Analyst, Noble Capital Markets, Inc.
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- End of a difficult year. Energy stocks rallied in the fourth quarter and ended the year up 1.8%, well underperforming the broad market. Weak results mirror the change in oil prices. Oil prices rose from $54 per barrel to $62/BBL in the fourth quarter in response to an improved global economic outlook and growing tension in the Middle East but were down for the year. The oil futures curve indicates that the market does not expect a recent rise in spot prices to continue. Natural gas prices were also weak in 2019.
- The outlook for energy stocks has improved but it is too early to turn positive. We continue to believe that oil prices are locked in a range of $50-$65 per barrel, a range that puts pressure on energy companies with high debt positions. Any movement outside that range will cause domestic producers to react by increasing/decreasing drilling and thus production which will eventually move prices back into the range. While too early to become positive on the group, we believe investors should maintain a modest exposure to energy stocks as a way to play any potential rise in energy prices.
Year and quarter in review
Exploration and production companies were glad to see the ball drop on 2019 and close out a frustrating year. A strong performance in the fourth quarter (XLE E&P index rose 6.9%) offset declines in the second and third quarter and left the index in the green (up 1.8%) for the year. Of course, this performance paled in comparison to the annual returns of the broader market (S&P 500 up 26.7% and the Russell 2000 up 18.7%). As expected, the performance of the XLE mirrored oil prices, which rose in the first quarter, fell in the second and third, and then rose again in the fourth. The rise in the February 2020 oil contract rose from $54 per barrel to $62/BBL in the fourth quarter in response to an improved global economic outlook and growing tension in the Middle East.
The market seems to be dismissing the long-term impact of the president's political saber rattling with Iran. We would note that future oil prices are below the current spot price. Clearly the market has grown weary of the constant threats of war by both countries and discounts the probability of war. Or, as we have discussed in the past, the market realizes the diminished role OPEC and the Middle East now have on West Texas Intermediate oil pricing.
When companies report December quarter and year-end results next month, we expect most management to report an increase in their hedge position and an increase in their drilling budgets. Most energy companies still set capital expenditures to stay within their operating cash flow but are anxious to turn on the spigots. With higher prices and cash flow, look for modest increases in drilling.
If energy investors are looking away from oil for relief, they won't get any help from gas producers. The February Henry Hub natural gas contract began the year near $3.00 per thousand cubic feet (mcf) and closed the year at $2.19 per mcf. The year's decline was largely felt in the last two months of the year when the contract fell $0.67 in response to mild weather.
As we look towards the new year, the outlook for energy stocks is improved but not yet positive. We continue to believe that oil prices are essentially locked in a range of $50-$65 per barrel. Any movement outside that range will cause domestic producers to react by increasing/decreasing drilling and thus production which will eventually move prices back into the range. We view the current movement to the upper end of the range as driven largely by political events and thus temporary.
Unfortunately, at prices within the $50-$65 range, most small energy companies are struggling to operate within free cash flow. They have cut operating costs, restructured debt, and focused on only the most profitable areas of production. Those with high leverage are vulnerable to line of credit downgrades that could create financial strain.
We favor energy companies with a large portfolio of drilling prospects and a strong balance sheet to fund future drilling or other expenditures. We believe energy companies with strong financial positions could begin to consider share repurchases in 2020 if energy prices remain strong and stock prices have not responded. While too early to become positive on the group, we believe investors should maintain a modest exposure to energy stocks as a way to play any potential rise in energy prices.
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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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