U.S. oil production still looks strong. Recent data points suggest that Texas is becoming an increasingly more important contributor to U.S. supply growth while the North Dakota Bakken--while still on the upswing--appears to be slowing down. Syria and Africa make for an eventful near-term global oil supply outlook. If we include Iran, recent events in these countries have removed almost 3 million barrels per day, or bpd, from the global oil supply picture. We consider the risk of a broader war between the various Middle Eastern oil producers rather low, but any negative developments could have an outsize impact on oil prices. The outlook for U.S. natural gas prices still looks decent, but recent data points are mixed. Natural gas storage levels have increased since our last review (a negative), but overall U.S. dry gas production growth is slowing and the natural gas rig count is picking up, which we consider positive developments. An uptick in rigs in the absence of any meaningful movement in the future curve signals producers' need to offset declining production volumes to generate cash flow. On the demand side, we think there is substantial room for U.S. natural gas demand to exceed expectations by 2020, led by higher LNG, pipeline exports, and industrial demand.
We continue to be impressed by U.S. crude oil productiongrowth. According to the U.S. Energy Information Administration, in June 2013 U.Scrude oil production, at 7.2 million bpd, was up 1 millionbpd over 2012 levels. As we mentioned last quarter, North Dakota oil productionremains strong, and it now stands at 821,000 bpd versus 665,000 bpd in 2012, a23% improvement. Texas' performance is even better, as the state's productionis almost 2.6 million bpd, up more than 600,000 bpd from 2012 levels, which is a30%-plus improvement. The difference in year-to-date growth numbers is starker,with North Dakota's production increasing just 83,000 bpd since the start of theyear, while Texas' production has increased 280,000 bpd over the sametime frame. The difference in production growth suggests that that that theproductivity at the once-prolific Bakken field has perhaps peaked. That said, theoverall healthy growth picture supports our contention that the United States'reliance on imports is declining, and by the end of 2013, China should becomethe world's largest importer of crude oil.
China's growing importance as a global oil importer is obviously not a newtrend, as China's thirst for oil has been one of the defining stories in theenergy space for many years. What is new, however, is that China's oil needsare increasingly being met by Middle Eastern oil, increasing the country'sinterest in the region at the same time as the United States' need for MiddleEastern oil imports dwindles. This trend makes the recent events in Syria andAfrica all the more important to China. Iran also remains a more long-standingconcern with international sanctions keeping production at 2.7 million bpd inAugust 2013 versus 3.6 million bpd in 2011. In total, the recent unrest in thesecountries has removed almost 3 million bpd from the global oil supply. China isan interested observer with stakes in two of Syria's largest oil firms (viaChina National Petroleum) and a 50% stake in one of Syria's largest oilfields (through Sinochem (600500)), and it is one of Syria's primary trading partners. Recently, China(through Sinopec (SNP)) also agreed to pay $3.1 billion for 33% of Apache's (APA) Egyptianoperations, agreed to loan Nigeria $1.1 billion in exchange for up to 200,000bpd of Nigerian oil by 2015, and already imports around 375,000 bpd of Iranianoil (China even received an exemption from the Iranian sanctions).
In Syria, the chemical attacks in the country are certainly disturbing, and the United States and Russia appear to have reached an agreement for Syria to give up its chemical weapons. While Syria is not a significant producer of oil (production levels were around 50,000-60,000 bpd recently, down from around 400,000 bpd prior to the conflict), but its location next to Iraq (3.2 million bpd), Kuwait (3 million bpd), Iran (2.7 million bpd), and Saudi Arabia (10 million bpd), along with the potential for any conflict in Syria to spread to its neighboring countries, is a concern for the oil markets. Russia and Iran are reported to be supplying weapons to the Syrian government, while Saudi Arabia and Qatar are supplying the rebels. Any U.S. military strike within Syria raises the risk of retaliatory attacks against Saudi Arabia and Qatar, further inflaming tensions. There are also pipeline geopolitics in play, as Syrian president Bashar al-Assad recently agreed to a deal for a pipeline to ship Iranian gas through Iraq to Syria, after previously rejecting a similar pipeline that would have shipped gas from Qatar--opening up a new export avenue for the country--through Saudi Arabia, Jordan, and Syria, and ending up in Turkey. The Qatar pipeline was rejected because it threatened the natural gas interests of Russia, which happens to be a Syrian ally. We consider the risk of greater turmoil in the Middle East due to actions taken in Syria low, but any negative developments are likely to have an outsize impact on oil prices given the large amount of oil production involved.
In Africa, the Libyan success story appears over for now while the environment in Nigeria has worsened; we've seen a loss of 1.2 million bpd of production as a result. In Libya, after an initial rebound to 1.6 million bpd of production by mid-2012 from a low of 45,000 bpd in mid-2011, production now stands at around 100,000-250,000 bpd. There have been a number of strikes in the region, as workers angry at government corruption and low wages have targeted attacks on Libya's export terminals with great success. At this stage, the Libyan government has suggested that it will look to diversify its pipelines in the future, but there are no clear immediate short-term fixes. In Nigeria, oil theft (long a problem in the country) has accelerated recently, thanks to the government's inaction (and seeming complicity in many cases), causing current oil production to dip to 1.9 million bpd from over 2.1 million bpd in 2011. Shell (RDS.A) and Eni (ENI), both large oil producers in the country, have been forced to shut in production because of sabotage. After years of frustration and limited governmental progress on a petroleum reform bill that could potentially introduce more attractive terms for the majors, Shell appears to be planning to sell several Nigeria acreage blocks as it moves to more attractive waters.
While there are some more dark clouds around the global supply outlook thanjust a few months ago, the global oil demand outlook looks more promising. OPEC,in its monthly oil market report, slightly boosted its 2013 global oil demandgrowth projection to 820,000 bpd from 790,000 bpd, while leaving its 2014projections of global oil demand growth of 1.04 million bpd unchanged. U.S. oildemand growth remains essentially unchanged from 2012 levels, while there aresigns that European oil demand will increase in future years owing to increasedcar sales in Germany, France, the U.K., and Spain. European oil demand is stillexpected to decline about 310,000 bpd in 2013 and 170,000 bpd in 2014 versus a540,000 bpd decline in 2012. Demand from China and the Middle East alsoremained fairly healthy with 5% and 6% demand growth rates versus last year'slevels.
Switching over to natural gas, we think the outlook fornatural gas prices still looks promising. On the negative side, natural gas storagelevels of 3,253 bcf as of Sept. 6 are about 5% below 2012 levels, butrecent storage injection levels have run close to and above the five-yearaverage. For example, our last quarterly report noted that storage levels were21% below last year's levels versus just 5% today. On a more positive note,U.S. dry gas production levels were around 66.3 bcf per day as of June, upabout 1.4% from the prior year, sharply down from recent growth rates of 5% in2012. In addition, the number of active U.S. gas rigs has ticked up to close to400 active rigs from about 354 rigs in June, indicating that more rigs areneeded to keep natural gas production levels flat. We consider this trend asignal that higher gas prices will be needed to grow natural gas production anddrilling activity.
On the demand side, natural gas consumption was down 1% from 2012 levels as ofSept. 11, because of a decline in power and residential demand, but we thinkthe overall gas demand picture looks different in 2020. By 2020, we project a 5bcf drop in demand from the power generation market, but a 40% increase inpetrochemical-related demand (as part of an overall 5 bcf per day increase inindustrial demand), plus substantial demand growth from Canada, Mexico, andLNG. In Canada, we expect that increasing demand in Ontario, declining gasproduction in the Western Canadian Sedimentary Basin, and surging productiongrowth from the Marcellus Shale will result in the displacement of Canadianimports through 2020. In Mexico, growing demand for gas cannot be met by thecountry's internal supply, meaning the U.S. will be called on to meet thesupply gap. In total, we expect pipeline exports to drive an incremental 3 bcfin demand. Finally, we expect LNG exports to result in demand for about 10 bcf/dof natural gas by 2020. This forecast suggests multiple ways to win forinvestors interested in taking advantage of the stronger outlook for U.S.natural gas prices over the medium to long term.
Energy Stocks for Your Radar
We have refreshed our list of recommendations this quarter with several new ideas. We've added Devon, Canadian Natural Resources (CNQ), and Tesoro (TSO), while keeping long-standing favorites National Oilwell Varco (NOV) and Ultra Petroleum (UPL). Devon has replaced Apache (APA) based on Apache's share price appreciation and the sale of Apache's 33% interest in its Egyptian operations, which we saw as a key catalyst. Similarly, Canadian Natural Resources has replaced Suncor (SU), and Tesoro has replaced HollyFrontier (HFC) because of share price appreciation for Suncor and HollyFrontier.
Top Energy Sector Picks Data as of 09-20-13
National Oilwell Varco (NOV)
Morningstar Rating: 3 Stars Fair Value Estimate: $85.00Economic Moat: WideFair Value Uncertainty: MediumConsider Buying: $59.50 National Oilwell Varco is in an interesting situation. In 2010, rig technology segment margins reached 30% as the firm benefited from delivering high-priced equipment ordered during the 2005-08 cycle during a cyclical lull in orders, which lowered the equipment delivery and associated costs for National Oilwell Varco. Today, National Oilwell Varco is delivering lower-priced equipment in a high-cost environment. For example, shipments from its Houston blowout preventer plant are expected to increase more than 80% in 2013. Further complicating matters, demand for North American equipment is soft, while international and offshore demand is high, as evidenced by the $3 billion-plus in orders in the last quarter. In this environment, the company has underestimated the costs for adding capacity to meet demand, and rig technology margins have suffered recently as a result. The rig technology segment also must deal with the fact that Petrobras has capped the number of deep-water floaters it needs at 42 in 2016, and the firm is now unlikely to be a source of rig equipment orders for National Oilwell Varco in the near future. We estimate that about 30% of the company's backlog is made up of Petrobras orders, but a surge in jack-up and land rigs orders will help it replace the loss in orders, in our view. National Oilwell Varco also recently doubled its dividend, which is a plus.
Morningstar Rating: 5 Stars Fair Value Estimate: $40.00Economic Moat: NarrowFair Value Uncertainty: HighConsider Buying: $24.00 Ultra's Pinedale and Marcellus assets represent one of the best one-two punches in North American upstream. The company remains well positioned to take advantage of a secular recovery in natural gas prices, thanks to its low-cost structure and long runway for growth. Ultra's balance sheet could tighten further over the next few quarters as hedges roll off, but under current strip prices the company should be fine from a covenant perspective. A takeout offer from one of the majors or a larger independent could help fast-track value realization: As a company, Ultra is both scalable enough and "bite-size" enough to attract a wide range of suitors. If Ultra is acquired, its takeout price could exceed our fair value estimate on a stand-alone basis.
Morningstar Rating: 4 Stars Fair Value Estimate: $87.00Economic Moat: NarrowFair Value Uncertainty: HighConsider Buying: $52.20 Devon has been one of the weakest-performing stocks in the U.S. upstream space over the past several quarters, thanks to a gas- and NGL-heavy production profile, underwhelming near-term growth prospects as a result of a slowdown in gas-directed drilling, and a handful of disappointments in oil-rich exploration plays that were supposed to drive the next leg of growth for the company. We think Devon's stock will continue to come under pressure as long as investors remain skeptical about the firm's ability to deliver oil and liquids growth and until additional steps are taken to highlight the underlying value of the company's assets. While we don't necessarily expect meaningful appreciation in Devon's stock price over the next few quarters, we think a plausible case can be made for the stock to be trading north of $85 by year-end 2015, implying close to 50% upside from today's price. Moreover, at less than $60 per share, the risk/reward ratio for Devon remains favorable, with approximately $15 of downside and $30 of potential upside in the name.
Canadian Natural Resources(CNQ)
Morningstar Rating: 5 Stars Fair Value Estimate: $50.00Economic Moat: NarrowFair Value Uncertainty: MediumConsider Buying: $35.00 Canadian Natural Resources is one of Canada's largest producers of low-cost natural gas and heavy oil/bitumen. Near-term headwinds include a bitumen emulsion leak at its Cold Lake project and ongoing transportation bottlenecks. We believe the emulsion leak will be resolved in time for the next steaming cycle and transportation bottlenecks are already being addressed. Steaming at the initial phase of its first large-scale commercial steam-assisted gravity drainage, or SAGD, project, referred to as Kirby, is underway with first oil expected in early 2014. By the middle of 2014 we look for Kirby to produce over 20,000 barrels per day of oil, increasing to 40,000 bpd by 2015. This is one of almost a dozen possible SAGD projects that contribute to Canadian Natural's 90 billion barrels of oil in place with expected netbacks (after royalties) of over CAD 30 per barrel. In addition to its SAGD projects, its Horizon oil sands mine has been experiencing smooth operations following a planned turnaround, and we look for improved cash flow going forward. When we look at these and other projects, we believe Canadian Natural can achieve 830,000 boepd of production by 2017, a 4.8% CAGR relative to 2012.
Morningstar Rating: 4 Stars Fair Value Estimate: $70.00Economic Moat: NarrowFair Value Uncertainty: Very HighConsider Buying: $35.00 Over the long term Tesoro will benefit the most from the increased flow of inland domestic and Canadian heavy crude to the West Coast. The firm is already transporting Bakken crude to its Anacortes, Wash., refinery, realizing a feedstock cost advantage relative to ANS as well as $4-$5/bbl in yield improvement. Eventually, Tesoro can replicate this success to a large degree throughout its California system, including its recently acquired Carson refinery. We do not think the market is properly crediting Tesoro for this potential uplift in earnings, cash flow, and returns that is likely to occur over the next few years.
Stephen Ellis does not own shares in any of the securities mentioned above.
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