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Oil & Gas Industry Outlook - March 2017

Nilanjan Choudhury

Crude Oil

Which market sector outperformed all others in 2016? Knowing which sector has been hot could point to where you should invest in 2017.

Investors looking for the ‘strongest performer’ for the U.S. stock market's price action last year need look no further than stocks in the energy sector. Yes, you heard right.

With a market-thumping 24% return, 'Energy' was the top performing S&P sector in 2016, proving that oil is indeed alive and kicking.

The Year 2016 in Review

Oil's 2016 journey was marked by sudden sharp sell-offs followed by swift recoveries. However, with crude's wild ride, we saw some big winners — and big losers as well. So essentially, investors with good stock-picking skills made a lot of money, while those who bet on the wrong stocks got absolutely hammered.

By February, prices plunged all the way to a low of $26 per barrel, thanks to the boom in shale oil production and rising output from OPEC. The dramatic slide prompted several analysts to make bold calls on a potential bottom. While some suggested prices might drop as low as $20 a barrel, gloomier estimates called for a sensational $10-per-barrel floor.

But thankfully, none of these bone-chilling forecasts were correct.

A historic OPEC production cut agreement, together with help from non-OPEC producers and slashing investments (in existing and new wells) saw oil prices more than double from their February lows to end the year around $54.

The Recent Sell-Off:

For the first couple of months of 2017, oil prices found themselves locked in a sideways trading range, as the tug-of-war over two powerful, opposing supply narratives continued.

Reports indicated an impressive 90% compliance level from the OPEC producers who pledged output cuts in an effort to tackle the three-year supply glut. However, a burgeoning rig count – pointing to the ever-increasing shale drilling activities – kept prices in check and within a band between $50-$55 a barrel.

And then prices broke below the psychologically important $50 threshold after U.S. government data showed that supplies – building since the beginning of the year – rose to record levels amid an increase in production.

At over 530 million barrels, current crude supplies are up 6% from the year-ago period and are at the highest level since the EIA began keeping records in 1982. Moreover, domestic output has steadily risen to more than 9 million barrels per day, the most since February 2016.

In fact, oil’s recent troubles have made ExxonMobil Corp. (XOM) and Chevron Corp. (CVX) the two worst Dow performers so far this year – down 10% and 8%, respectively.

Energy Roadmap for 2017:

Despite hope offered by the biggest oil deal in a decade and a new pro-fossil fuel administration in the White House, investors would be mistaken if they expect oil to double again in 2017.

As of now, the commodity has erased most of the gains since OPEC announced output cuts in November, notwithstanding speculation that the cartel members could exercise an option to extend its pact by another 6 months to the end of 2017.

At the crux of the matter is the rising flood of U.S. shale-driven production. Now at a financial equilibrium, the shale firms are putting more rigs and employees back to work.

Throughout the downturn, producers worked tirelessly to cut costs down to a bare minimum and look for innovative ways to churn out more oil from rock. And they managed to do just that by improving drilling techniques. With these efforts, many upstream companies have repositioned themselves to adapt to the new $50 oil reality and even thrive at those prices.

As is being witnessed, the recent uptick in U.S. shale production has put more pressure into the market.

In other words, while OPEC's moves to trim output and rebalance the demand-supply situation has stabilized the market to a large extent, in the process it has incentivized shale drillers to churn out more.

To sum it up, oil’s future direction will depend on the battle between the OPEC-led output cuts and the increase in U.S. shale production.

Natural Gas

Over the last few years, a quiet revolution has been reshaping the energy business in the U.S. The success of ‘shale gas’ – natural gas trapped within dense sedimentary rock formations or shale formations – has transformed domestic energy supply, with a potentially inexpensive and abundant new source of fuel for the world’s largest energy consumer.

With the advent of hydraulic fracturing (or "fracking") – a method used to extract natural gas by blasting underground rock formations with a mixture of water, sand and chemicals – shale gas production is now booming in the U.S. Coupled with sophisticated horizontal drilling equipment that can drill and extract gas from shale formations, the new technology is being hailed as a breakthrough in U.S. energy supplies, playing a key role in boosting domestic natural gas reserves. As a result, once faced with a looming deficit, natural gas is now available in abundance.

Prices Slumped to 17-Year Lows in 2016, Then Recovered:

With production from the major shale plays remaining strong and the commodity’s demand failing to keep pace with this supply surge, natural gas prices hit 17-year lows of around $1.6 per million British thermal units (MMBtu) in the first quarter of 2016. The glut was further exacerbated by lackluster industrial requirement.

Thereafter, successive below-average builds on the back of warmer temperature across the country cut into the year-over-year storage surplus. And nine months later, the commodity made a dramatic turnaround. Natural gas ended 2016 within touching distance of $4 per MMBtu -- an annual gain of 59.4%, the best in 11 years. This was also aided by slowing output from shale basins amid a December cold blast that stoked heating demand.

...Only to Fall Again This Year:

Unfortunately, selling has come back to the market since then. Year-to-date, natural gas has performed the worst among major commodities. It dived more than 35% through late February and while prices have rebounded somewhat in March, they are still struggling to stay above $3 for a prolonged period.

With the winter heating season – which runs from Nov 1 to Mar 31 – coming to an end and the injection season set to start, fundamentals point to 'lower for longer' prices. Agreed, this year there is around 16% less natural gas in storage compared to the year-ago period, but worryingly, the current stock is 15% more than the five-year average for this time of the year.

A warmer winter translated into weaker demand for the heating fuel and upended demand forecasts. And now, as March comes to a close, one would expect tepid demand for the commodity with spring-like weather expected over most parts of the nation in the upcoming weeks.

The depressed pricing environment weighed on natural gas drillers like QEP Resources Inc. (QEP), Southwestern Energy Co. (SWN) and Chesapeake Energy Corp. (CHK) – all Zacks Rank #3 (Hold) companies –which slid 34%, 30% and 26%, respectively year-to-date. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Our View: More Upside for Both Oil & Gas

Oil: In our view, crude prices in the next few months are likely to exhibit a sideways-to-bullish trend, mostly trading in the $45-$55 per barrel range. Even as North American shale supply remains strong, oil will be supported by the continued tightening of world oil markets through OPEC curbs and improved global demand outlook.

But this does not mean that we will not see any short-term pullbacks. On the whole, we expect oil prices in 2017 to be higher than 2016 levels, but remain significantly below $100-per-barrel, at which oil traded prior to the commodities slump that started in July 2014.

Natural Gas: Long-term fundamentals for the commodity continue to be bullish on the back of structural imbalances. While domestic natural gas production is expected to rebound this year, the growing use of liquefied natural gas (or LNG), booming exports to Mexico, replacing coal-fired power plants and higher demand from industrial projects will likely take care of the increased output. The resulting effect will ensure natural gas storage keeping pace with the 5-year average in the near future, with deficits piling up later on.

By the onset of summer months, these secular headwinds will start to have a positive impact on natural gas sentiment and price.

Valuation Also Signals More Upside

Going by the EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation and amortization) ratio, which is often used to value oil and gas stocks, given their significant debt levels and high depreciation and amortization expenses, the industry doesn’t look expensive at this point.

The industry currently has a trailing 12-month EV/EBITDA ratio of 8.38, which is lower than the median value of 9.48 over the past 1 year.

Additionally, the reading compares favorably with the market at large, as the current EV/EBITDA for the S&P 500 is at 10.99 and the median level is 9.91. The industry’s favorable positioning compared to the overall market certainly signals more upside.

What the Zacks Industry Rank Indicates

Oil/Energy is one the 16 broad Zacks sectors within the Zacks Industry classification. We rank 265 X industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. (To learn more visit: About Zacks Industry Rank.)

The oil/energy industry is further sub-divided into the following industries at the expanded (aka "X") level: Oil and Gas - Integrated - United States, Oil and Gas - Drilling, Oil and Gas - Exploration and Production - United States, Oil and Gas - Production Pipeline - MLP, Oil and Gas - Field Services, Oil and Gas - Integrated - International, Oil and Gas - Production and Pipelines, Oil and Gas - Mechanical and Equipment, Oil and Gas - Integrated – Canadian, and Oil and Gas - Refining and Marketing.

We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than 2 to 1.

The Zacks Industry Rank is #7 for Oil and Gas - Integrated – Canadian, #72 for Oil and Gas - Exploration and Production - United States, #75 for Oil and Gas - Drilling, #82 for Oil and Gas - Integrated - United States, #89 for             Oil and Gas - Production and Pipelines, #102 for Oil and Gas - Refining and Marketing, #102 for Oil and Gas - Integrated - International, #102 for Oil and Gas - Production Pipeline – MLP, #172 for Oil and Gas - Field Services and #174 for Oil and Gas - Mechanical and Equipment.

The location of these industries suggests that the general outlook for the oil/energy space as a whole is leaning toward ‘Positive.'

Early Q1 Predictions Look Promising

Ending the dismal trend from the past few quarters, a look back at the Q4 earnings season reflects that the overall results of the Oil/Energy sector finally turned the corner, driving the aggregate growth picture for the S&P 500 index.

The Oct-Dec 2016 period turned out to be a rather good one with the OPEC deal and extreme weather conditions engineering a hefty rise in oil and gas prices during the fourth quarter.

A historic OPEC production cut agreement, together with help from non-OPEC producers saw oil prices end the year at $53.72 a barrel, representing a gain of 11.4% sequentially and 45% for the year. Meanwhile, natural gas embarked on its own upward journey, with futures jumping around 25% just in the fourth quarter. Ending the year at $3.724 per million Btu (MMBtu) – up 59% from 2015 – the heating fuel was buoyed by a cold snap that translated into strong demand.

As a result, following 8 back-to-back quarters of earnings declines, analysts said that the sector was likely to get better in the fourth quarter and clock its first positive earnings growth after 2 years. With estimate revisions going up following OPEC’s Algeria grandstand, the Oil/Energy sector’s earnings were expected to improve 8.8% from the fourth quarter 2015 levels.

True to the predictions, the sector came out swinging. For the sector components on the S&P 500 index, total Q4 earnings were up 16.7% on 1.8% higher revenues.

The picture looks rather encouraging for the upcoming Q1 earnings season as well. This is not surprising, considering that oil and gas both fell to multi-year lows in the year-ago period. While earnings estimate revisions for the Oil/Energy sector’s first quarter are still not available, the top-line is likely to show an impressive growth of 33% from the first quarter 2016 levels.

For more information about earnings for this sector and others, please read our Earnings Preview report.

Zacks' Top 10 Stocks for 2017

In addition to the stocks discussed above, would you like to know about our 10 finest buy-and-hold tickers for the entirety of 2017?

Who wouldn't? Last year's market-beating Top 10 portfolio produced 5 double-digit winners. For example, oil and natural gas giant Pioneer Natural Resources and First Republic Bank racked up stellar gains of +44.9% and +44.3% respectively. Now a brand-new list for 2017 has been hand-picked from 4,400 companies covered by the Zacks Rank.  See the 2017 Top 10 right now>>

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Exxon Mobil Corporation (XOM): Free Stock Analysis Report
Southwestern Energy Company (SWN): Free Stock Analysis Report
QEP Resources, Inc. (QEP): Free Stock Analysis Report
Chevron Corporation (CVX): Free Stock Analysis Report
Chesapeake Energy Corporation (CHK): Free Stock Analysis Report
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