U.S. tight oil production growth continues to be the dominant supply story in energy, reshaping market fundamentals in the U.S. and abroad. Natural gas production remains stubbornly strong, with full credit due to the Marcellus. We're seeing the Majors begin to dial back capital spending, favoring projects that generate long-term production plateaus rather than more traditional oil and gas developments, where decline rates accentuate the challenge of reserve replacements.
We continue to believe that the dominant theme in the oil patch is U.S. production growth. Certainly the impact of Iran, Libya, Iraq, and Nigeria on world markets is noteworthy, and if each of these were producing at full capacity we would be staring at much lower oil prices. However, it is the surging growth of U.S. oil, led by tight oil plays like the Bakken, Eagle Ford, and Permian, that represent the greatest near-term downside risk to prices, in our view. The EIA recently increased its baseline projections for U.S. oil production, forecasting 2020 crude oil production at 9.6 million barrels a day, up from 7.4 million barrels a day forecast just last year. This would put U.S. production of crude on par with Saudi Arabia and Russia and account for roughly half of U.S. oil consumption.
Because much of the production growth stems from light, tight oil, we're seeing domestic production backing out imports of light oil along the Gulf Coast. A veritable glut of light oil is developing along the Gulf as more oil accumulates than refiners can process, driving the spread between domestic (WTI) and international (Brent) crude pricing wider. This is good news for domestic refiners, which benefit from low-cost feedstock. The news is less rosy for domestic producers, but so long as crude prices stay above $85 per barrel we expect robust production growth.
Producers have responded rationally to low natural gas prices, and have shifted virtually all drilling capital toward oil. Production in dry gas basins is in decline, with one key exception: the Marcellus. The combination of prolific wells and increasing pipeline takeaway capacity has resulted in surging production--we estimate exit-rate 2013 Marcellus production of around 13 billion cubic feet per day, accounting for close to 20% of total dry gas production. This, along with gas associated with oil drilling, represents a cheap source of new production, placing a lid on prices in the near term. However, we continue to believe that declining dry gas production and increasing demand will result in gas prices moving substantially higher over the next five years. In the United States, we see more commodity upside to gas than oil.
On a price/fair value basis energy appears to be the most attractive sector this quarter, at 0.92, or an aggregate 8% discount to fair value. Within energy, we see value across industries, with integrated oil and gas, E&Ps, drillers, refiners and midstream all priced at roughly a 10% discount, while equipment and services firms are close to fully valued. As always, there is substantial variation among firms, and encourage investors to seek stock-specific opportunities rather than making purely macro calls.
Energy Stocks for Your Radar
We continue to favor gas-weighted E&Ps, with Ultra Petroleum (UPL) and Devon Energy (DVN) again making our list this quarter. Ultra is the most leveraged company in our coverage to a rebound in natural gas prices, and Devon is amid a production mix shift toward greater liquids production, which should drive production growth. Among firms with oil exposure, we think Canadian Natural Resources (CNQ) and Denbury Resources (DNR) are both highly attractive. Canadian Natural is a play on oil sands development, where we believe the firm's exposure to plateau projects like Horizon and Cold Lake will support stable long-term production and improving returns on capital. Denbury is an expert at tertiary oil recovery, and aims to deliver steady production growth without chasing the next shale play. We've also added a midstream name this quarter. Energy Transfer Partners (ETP) has resumed distribution growth after a series of acquisitions and a plan to develop an LNG export facility supports longer-term growth prospects.
Top Energy Sector Picks Data as of 12-17-13
Star Rating: 5 Stars Fair Value Estimate: $40.00 Economic Moat: Narrow Fair Value Uncertainty: High Consider 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.
Star Rating: 4 Stars Fair Value Estimate: $87.00 Economic Moat: Narrow Fair Value Uncertainty: High Consider Buying: $52.20 Devon has been one of the weakest-performing stocks in the U.S. upstream space over the last 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 about $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)
Star Rating: 4 Stars Fair Value Estimate: $46.00 Economic Moat: Narrow Fair Value Uncertainty: Medium Consider Buying: $32.20 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 more than 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 more than 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.
Star Rating: 4 Stars Fair Value Estimate: $23.00 Economic Moat: Narrow Fair Value Uncertainty: High Consider Buying: $13.80 Denbury has a simple strategy: Acquire extremely mature oil fields on the cheap, inject carbon dioxide into the reservoir (commonly referred to as tertiary recovery), and expand production from nearly nothing to several thousand barrels per day. This is easier said than done, as the process is fraught with logistical challenges and technical barriers. Generally, tertiary recovery projects contain marginal economics, but we think Denbury's strategy of staged projects will provide multiyear production growth at favorable economics.
Energy Transfer Partners(ETP)
Star Rating: 4 Stars Fair Value Estimate: $70.00 Economic Moat: Narrow Fair Value Uncertainty: Medium Consider Buying: $49.00 After a series of acquisitions, Energy Transfer Partners is now solidly on a growth trajectory, as evidenced by resumed distribution growth this quarter. Acquired businesses now make up about 40% of cash flows and account for a lion's share of growth. Savvy financial engineering with parent company Energy Transfer Equity reduced units outstanding, supporting faster distribution growth in coming quarters. And the announcement of an LNG export development plan that will require no capital or credit commitments from the partnership supports Energy Transfer's long-term growth prospects.
Jason Stevens has a position in the following securities mentioned above: UPL