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The trading ranges for
oil and gas haven't changed that much since we last touched base with Phil
Weiss, senior analyst at Argus Research, but the entire landscape for both
North American and international oil and gas exploration has shifted
dramatically. In this interview with The Energy Report, Weiss summarizes the impacts of increased
production both at home onshore and in international waters, sharing some
names he finds best positioned to benefit in the coming year.
The Energy
Report: It's been over two years since your
last interview with us.
At that time you told us you were using $85/barrel (bbl) oil in your modeling
for 2011. Is this "déjà vu all over again"?
Phil
Weiss: In finalizing my 2013 forecast, I
came pretty close to that price; I'm using $87/bbl for West Texas
Intermediate (WTI). But back then, Brent and WTI traded relatively close to
each other, with WTI at a slight pas premium. That's changed pretty
dramatically. This year I expect an ~$18/bbl premium
for Brent over WTI. I'm modeling that premium at $14 in 2013.
The surge
in onshore U.S. production has been a big factor; relatively low Brent supply
has been another. Production from the Bakken and the Eagle Ford has created
"stranded" oil in the U.S. and significant inventory buildup at the
Cushing, Oklahoma terminal. Producers that have oil that's not in the WTI
category have been doing relatively better because they're getting more for
their product. This trend has also made for some dramatic changes in the
refining market, especially for those companies that are U.S. based.
TER: What
other major industry shifts have you observed?
PW: Some
projections for next year indicate that U.S. production could be at its
highest levels since 1992. That's a pretty big deal. BP's Macondo disaster in
the Gulf caused a big slowdown in offshore activity and now we're back near
pre-Macondo levels. A number of new discoveries, such as the natural gas
finds offshore East Africa, have also been big. The deepwater opportunities
are much bigger now. It's not just a Brazil or Gulf of Mexico story. We have
East and West Africa, Australia and other areas in Asia.
Some
activity has also recently started in the Arctic. Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) got an
opportunity to do a little bit of work in the past year, though not as much
as it had hoped. Yesterday's incident involving the Kulluk floating drilling
rig in Alaska is another indication of how difficult and expensive it is to
work in the arctic. Fortunately, the rig is stable and it appears the
inspection team is reporting that there is no leakage. Shell has great
prospects in regions such as the deepwater Gulf of Mexico and Australia as
well as unconventional shale positions in the U.S. and Canada. Shell is
currently the largest player in the LNG market among the integrated oil
companies with more than 20 million tons per annum (Mtpa) of current
capacity. This figure could increase to about 30 Mtpa by this decade's end.
Shell currently has more than 60 new projects and options. At maturity, the
company represents approximately 20 billion barrels of oil equivalent of new
resource potential, including major projects in LNG, deepwater, tight gas,
liquids-rich shales and traditional plays. These projects underpin
management's cash flow and production growth targets.
There was
also the deal between Exxon Mobil
Corp. (XOM:NYSE) and Rosneft Oil (ROSNS:RTS) to do
work in the Arctic outside of Russia.
TER: What's
your view on peak oil?
PW: To me,
the issue is really more about cheap versus expensive oil. For the most part,
the cheap oil has been found. The oil we're finding now is costing more to
produce. The Energy Information Administration put out a report recently
stating that they expected the U.S. to be energy independent by 2020. Part of
that is based on the growth in U.S. onshore production. What we don't know
for sure is if we're accelerating production going forward, because these
wells have really high decline rates. We don't know if the estimated
recoveries from these wells are really accurate. It's also unclear if we're
really accelerating production from these wells through hydrofracturing
techniques.
People
like Arthur Berman have said there's not as much gas or oil in these
unconventional plays as people think, although a lot of companies have
invested heavily in a belief that there is. I do know that the cost of
getting these hydrocarbons out of the ground is increasing. It does seem to
me that cheap oil has largely been found and it will likely cost a lot more
to meet some of the production targets companies have when they're drilling
wells that show fairly quick production declines. It costs a lot to keep
drilling new wells in order to keep production up.
TER: Let's
talk about the broad picture and where you see the best investment
opportunities in the year ahead, starting with oil. What's your view of the
domestic potential versus all the global activity going on now?
PW: Oil
prices have been relatively steady—averaging about $94/bbl in 2012 and
about $90 in H2/12. I'm looking for WTI to average $87/bbl next year with
probably a slight increase to $90 for 2014. We've been in a trading range for
the last six months and if we can kind of stay within that range, without a
lot of geopolitical risk or the economy really blowing up, we should be fine.
Oil
services companies, while they've struggled some in the past year, are
generally in the best positions in this environment. Schlumberger Ltd. (SLB:NYSE) and Baker Hughes Inc. (BHI:NYSE) both
preannounced that North America activity in the fourth quarter is weaker than
expected, with contractual delays and seasonal slowdowns in their
international locations, but I still think that oil services companies and
rig companies are generally pretty confident that oil prices are high enough
to support their activity. I also believe that some of the issues Baker is
having are company specific.
Barclays
put out its semiannual spending survey earlier this month. They expect capex
to grow about 7% next year, mostly in international locations. When planning
for 2013, producers are thinking about an $85/bbl oil price and say that it
would need to fall in the mid- to high sixties before it would have an impact
on their budgets. An $85/bbl environment should be able to sustain spending,
although service rates have been hurt due to overcapacity for pressure
pumping equipment, in particular. Some other services are seeing pricing
pressure as well.
With
growth in offshore and some of the other markets I think that service
companies are really well positioned to benefit with oil prices at these
levels. Their stock prices, however, have lagged their business performance
because people are concerned about things like pressure pumping margins.
On the
natural gas side, prices hit 10-year lows back in April and then more than
doubled, and have now pulled back about 10%. There's a lot of associated gas
that comes with all these new liquids-rich U.S. wells, which has helped to
keep natural gas production pretty high. Some people expect that to start to
fall off. I think the big thing that's driven gas prices up from their lows
is expectations for a cold winter. As you get into December, you expect
temperatures to get colder, but gas prices have pulled back a little because
the weather has been warmer than expected. Without a cold winter, gas prices
could go down again. So I remain a little hesitant on the gas-heavy
companies. I favor those that are more tilted toward oil.
Among the
majors, I think that Chevron
Corp. (CVX:NYSE) is
positioned as the best large, integrated player. It has a very strong balance
sheet and a good path to production growth because of projects such as Gorgon
and Wheatstone. In addition, about 70% of its production is liquids, which
helps it deliver the best profitability per produced barrel of any company in
my coverage universe. On the exploration and production (E&P) side, I
think that ConocoPhillips (COP:NYSE) is well- positioned
and I like the fact that it pays a generous dividend. That's a big benefit
because even if oil prices struggle and the market doesn't do that well, you
get a nice healthy dividend and can, in essence, be paid while you wait.
TER: Any other
ones you think are worth mentioning?
PW: Moving to
the downstream part of the sector, I really like Phillips 66 (PSX:NYSE). It's a
differentiated refiner because it also has a midstream chemicals business.
It's throwing off a lot of cash flow. It recently raised its dividend by
25%—meaning it has increased its dividend by 56% since paying its first
dividend in July. The company is also buying back stock and plans to pay off $2
billion of debt next year. With the price differences between WTI and other
oils, I think certain U.S. refiners have become better positioned because of
access to advantaged crudes. They also benefit from the ability to use cheap
natural gas in their operations. In addition, they have greater ability to
export refined products, so they are not materially impacted by weaker U.S.
fuels demand. Phillips is also differentiated from peers in that it has
chemicals and midstream operations to generate additional income. Phillips
also plans to contribute transportation assets and form a master limited
partnership that should IPO in the second half of next year, providing
additional opportunities for shareholders to benefit. I think the chemicals
business is going to be pretty strong. It doesn't have a lot of capital
requirements so I think Phillips is really well positioned.
HollyFrontier
Corp. (HFC:NYSE) is
another refiner that's pretty well positioned in this environment. That stock
did so well in 2012—up between 90% and 100% for the year—that
it's hard to see it duplicating that performance again. But the structural
changes in the U.S. market with access to cheaper crudes and lower-cost
natural gas leave these companies well positioned.
Coming
back to the services side for a second, the names that I like the best within
my coverage are Schlumberger and Halliburton
Co. (HAL:NYSE).
Halliburton looks cheaper based on traditional valuation metrics, but it is a
bit more exposed to North American unconventional activity. Schlumberger is
the industry leader. It has the biggest presence in international markets and
is strong in deepwater, too. Its seismic business is also doing well. I
prefer both of these companies to Baker Hughes. I have some concerns about
Baker's working capital management and the company's inconsistent
performance. It has to work through some accounts receivable and inventory
issues. On the rig side, I think that Transocean
Ltd. (RIG:NYSE; RIGN:SIX) is a nice
turnaround play for value investors. As I mentioned earlier, the oil price
environment certainly looks favorable for offshore activity. There's a lot of
improvement that can come for it as it benefits from growth in the deepwater
market. It has a $30+ billion revenue backlog and also recently closed on the
sale of a large portion of its commodity jackup fleet. After a good first
quarter, the shares have not performed as well the last three quarters, but I
see signs the operations are improving, and as long as that continues, the
company has the potential to provide solid returns.
Earlier
today, Transocean issued a press release indicating it has reached a
settlement with the Department of Justice (DOJ) over its Macondo-related
liabilities. Under the agreement's terms, Transocean will pay $1.4 billion
($1.4B) in Clean Water Act civil penalties over a period of three years. It
will also pay $100 million ($100M) within 60 days of the agreement receiving
court approval, $150M over three years to the National Fish and Wildlife
Foundation and $150M over five years to the National Academy of Sciences. All
payments are not deductible for tax purposes. Transocean had taken a $1.5B
reserve for this aspect of Macondo and a total reserve of $2B for its role in
Macondo. The shares have reacted positively to the announcement; they are
currently up about 7.5% today. Macondo was likely an overhang on the shares
of Transocean. Settling with the DOJ for a figure slightly below what the
company had provided should be a positive for the shares. In recent quarters,
the company's operations have shown signs of improvement and the operating
environment is positive for offshore activity, particularly in the deepwater
areas. The settlement removes one of the risks hampering share price
performance and has the potential to get investors to focus on the
performance of the company's business.
TER: Do you
see any good upside with the market and companies that are more oriented
toward the gas end of the business?
PW: I'm going
to model something like a $3.60/Mcf gas environment in 2013, which is an
improvement from last year's $2.75/Mcf. A lot will depend on a couple of key
factors. One is if we have a cold winter that'll drive a lot of gas out of
inventory and put us into a different position as we exit the winter season
than we were last year. The other is dependent on places like the Marcellus
where there are a lot of wells that have been drilled but not yet connected.
So, we don't know exactly how much gas they could bring on-line and how that
could impact inventory.
We also
have to get a better handle on how much impact associated gas is really
having on production. Certainly the number of rigs that are reported as being
dedicated to drilling for gas has fallen dramatically. It's at multi-year
lows, which would indicate that gas production is going to fall. However,
even though all the time the rig count has been falling, production has been
pretty healthy. There are some questions as to whether or not companies have
some flexibility as to how they report those rigs to Baker, which reports the
U.S. rig count on a weekly basis.
If any one
of those things goes against us, natural gas companies with a good amount of
production could do better. While I don't have a buy on it right now, I do
like Devon Energy Corp. (DVN:NYSE). I think it's a well managed
company. It did a couple of nice joint ventures in the past year with two
Asian companies, Sumitomo Corp. (STMNF:OTCPK) being one and Sinopec
International Petroleum Exploration & Production Corp. is the other where
it's joint ventured some of its U.S. acreage to benefit its cost structure.
It has a healthy balance sheet, and I think that's one that if you're looking
for a natural gas-oriented play, has some potential.
Anadarko
Petroleum Corp. (APC:NYSE) is
another company you could look to if you think natural gas is going to get
better. While I don't have a Buy rating on it, I do think about it a lot
because it's had a lot of exploration success and a good pool of assets. It's
pretty well positioned in East Africa with Mozambique and also has some good
positions in the U.S.
TER: Do you
have any thoughts on ETFs (exchange-traded funds) in general?
PW: I don't
cover any ETFs but I think they are an interesting vehicle for investors
interested in the space, who don't want to pick specific stocks but like a
group or groups within it. So, if you're interested in the services, there
are a couple ETFs that are oriented toward services. You could do the same
thing with some of the other groups within the sector. I don't really like
the ones that are directed toward the commodities themselves just because I
think that there are a lot of unknowns that could affect them. The futures
contracts expire and have to be replaced. There's a lot of decay in value
that happens there. But if you're looking to play a specific area of the
sector and you're not as well-versed in terms of analyzing these companies,
it can be a way to get a little bit more diversified play on the sector.
TER: Do you
have anything else you'd like to mention at this point?
PW: I might
add that because gas prices are still somewhat depressed, we could see some
more transactions in terms of assets. I don't expect to see a lot of
companies swallowing other companies unless those companies are relatively
small and focused in just one or two plays. The larger companies I talk to
don't seem all that interested in acquiring smaller peers. An important
factor in this thought process may be that, especially when it comes to
unconventional plays, there tends to be a manufacturing model where there's
an advantage to having size and scale in a particular area. The idea is that
it's probably better to look to grow in areas where you already have a
presence, such as when Chevron bought some Permian assets from Chesapeake Energy Corp. (CHK:NYSE) a few
months ago, further expanding its presence in the area.
Companies
like Occidental Petroleum Corp. (OXY:NYSE) have also done a really good
job of going out and buying assets to increase their position in plays where
they already have acreage. It has added a lot of acreage in plays such as the
Permian from small operators. We still may have some risk with companies that
were too gas focused. If they weren't hedged and if gas prices aren't strong
enough, they could still have some trouble due to lack of funding.
TER: So, to
summarize, what strategy would you suggest generally for investors to
consider, in order to try to make some money in 2013
or minimize their downside?
PW: I think
that the services are definitely an interesting part of the market to think about.
If you're a more conservative investor, I would look to those companies
paying a nice dividend. I mentioned Conoco and Chevron, which both pay pretty
good dividends. I don't think Exxon's dividend is enough to entice me at
these levels, plus the company is a little more gas oriented than some of the
others. Even though it's a Hold-rated stock, you could probably even look to
Shell, because of its nice dividend.
I tend to
be a stock picker as opposed to taking a basket approach. But if you see a
certain sector of the market that you like and you're uncomfortable picking
specific stocks and find an area that you like, I think an ETF can be a
little bit more conservative way to play the sector.
TER: That's a
good overall view of the industry and some ideas for our readers to consider.
Thanks for joining us today, Phil.
PW: Thanks
for the opportunity.
Phil Weiss is a
senior analyst covering the energy sector at Argus Research Corp. He has also
worked as a senior institutional writer for T. Rowe Price, and as a
writer/analyst/co-portfolio manager for The Motley Fool's Cash King/Rule
Maker Portfolio. He started his career with Deloitte & Touche, where he
specialized in international tax research and planning. He has a Bachelor of
Science from Rutgers University. He is a CFA charterholder.
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DISCLOSURE:
1) Zig Lambo of The Energy Report conducted this interview. He
personally and/or his family own shares of the following companies mentioned
in this interview: None.
2) The following companies mentioned in the interview are sponsors of The
Energy Report: Royal Dutch Shell Plc. Interviews are edited for clarity.
3) Phil Weiss: I personally and/or my family own shares of the following
companies mentioned in this interview: Transocean. I personally and/or my
family am paid by the following companies mentioned
in this interview: None. I was not paid by Streetwise Reports for
participating in this interview.
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