What's Keeping Oil Prices Below $100 a Barrel? - Industry Outlook

By Zacks | Updated August 21, 2014 AAA

OUTLOOK

Crude Oil

Record domestic production and the easing of geopolitical fears have combined to keep oil prices below the major psychological threshold of $100 per barrel.

In particular, a spike in U.S. output -- now at their highest levels since 1986 -- has ballooned crude inventories to around 370 million barrels, thereby creating a supply glut. The commodity’s recent lack of momentum also stems from perceptions of easing tensions over Iraqi oil exports. Till now, the militant uprising is limited to the northern part of the country, while Iraq’s production region in the south remains largely unscathed. Concerns about the European economy and the resumption of output from Libya’s largest oilfield have been further weighing on sentiments.

Partly offsetting this unfavorable view has been a host of largely positive economic data, pointing towards improvement in the U.S. labor market. This has prompted hopes for robust fuel and energy demand in the world’s biggest oil consumer. The bullish momentum has been aided by the Federal Reserve’s measured Taper reduction. The central bank -- asserting that the U.S. economy was strong enough -- trimmed bond repurchases to $25 billion a month in July, substantially down from the peak of $85 billion.

In the medium-to-long term, while the Western economies exhibit sluggish growth prospects, global oil demand is expected to get a boost from sustained strength in China, which continue to expand at a healthy rate despite some moderation.

According to the Energy Information Administration (EIA), which provides official energy statistics from the U.S. Government, world crude consumption grew by an estimated 1.3 million barrels per day in 2013 to a record-high level of 90.4 million barrels per day. The agency, in its most recent Short-Term Energy Outlook, said that it expects global oil demand growth by another 1.1 million barrels per day in 2014. But importantly, the EIA’s latest report assumes that world supply is likely to outpace consumption growth and go up by 1.5 million barrels per day in 2014.

In our view, crude prices in the next few months are likely to exhibit a sideways-to-bearish trend, mostly trading in the $90-$100 per barrel range. As North American supply remains strong and the groundbreaking agreement with Iran makes it easier for the country to sell the commodity, we are likely to experience a pressure in the price of a barrel of oil.

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. In fact, natural gas inventories in underground storage hit an all-time high of 3.929 trillion cubic feet (Tcf) in 2012. The oversupply of natural gas pushed down prices to a 10-year low of $1.82 per million Btu (MMBtu) during late April 2012 (referring to spot prices at the Henry Hub, the benchmark supply point in Louisiana).

However, things have started to look up somewhat following a frigid winter that saw the heating fuels’ demand take off. This pushed commodity prices to its highest level in 5 years earlier this year.

But with recent natural gas stock builds continuing to outpace the historical norms on the back of strength in summer production and mild weather, the commodity’s near-term fundamentals remain rather lukewarm, at least till the next heating season starting November.

ZACKS INDUSTRY RANK

Oil/Energy is one the 16 broad Zacks sectors within the Zacks Industry classification. We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. To learn more visit: About Zacks Industry Rank

The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #88 and lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative.

The oil/energy industry is further sub-divided into the following industries at the expanded level: Oil – U.S. Integrated, Oil and Gas Drilling, Oil – U.S. Exploration and Production, Oil/Gas Production Pipeline MLP, Oilfield Services, Oil – International Integrated, Oil – Production/Pipeline, Oilfield Machineries and Equipment, Oil–C$ Integrated, and Oil Refining and Marketing.

The ‘Oil – U.S. Integrated’ is the best placed among them with its Zacks Industry Rank #18, comfortably placing it into the top 1/3rd of the 260+ industry groups, where it is joined by the ‘Oilfield Machineries and Equipment’ and ‘Oil – International Integrated’ with respective Zacks Industry Ranks #45 and #79.

The ‘Oil and Gas Drilling’ -- with a Zacks Industry Rank #89 -- moves just out of the top 1/3rd and into the middle 1/3rd. The ‘Oil – U.S. Exploration and Production,’ ‘Oil/Gas Production Pipeline MLP’ and ‘Oil – Production/Pipeline,’ with Zacks Industry Ranks of #91, #97 and #104, respectively.

However, all the other sub-sectors – Oil Refining and Marketing, Oilfield Services, and Oil–C$ Integrated – are featuring in the bottom one-third of all Zacks industries with respective Zacks Industry Ranks of #209, #218 and #221.

Looking at the exact location of these industries, one could say that the general outlook for the oil/energy space as a whole is leaning toward ‘Neutral’ to 'Positive.'

EARNINGS TRENDS

A look back at the just-concluded Q2 earnings season reflects that as far as overall results of the Oil/Energy sector is concerned, it displays a bullish trend. Crude prices rose to their highest level in nine months during this period, as tensions over Iraq continued to feed supply concerns in the Middle East.

During the June quarter, earnings rose 12.2% year over year, a substantial improvement from the 1.6% decrease witnessed in the previous quarter. There was some progress on the revenue front too, which was up 2.1% in the second quarter as against a gain of just 0.8% in the first quarter.

The sector has also been encouraging in terms of beat ratios (percentage of companies coming out with positive surprises). While the earnings "beat ratio" was good at 55.6%, the revenue "beat ratio" was even more impressive, at 64.4%.

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

OPPORTUNITIES

Considering the turbulent market dynamics of the energy industry, we always advocate the relatively low-risk conglomerate business structures of the large-cap integrateds, with their fortress-like balance sheets, ample free cash flows even in a low oil price environment and growing dividends.

Our preferred name in this group remains Chevron Corp. (CVX). Its current oil and gas development project pipeline is among the best in the industry, boasting large, multiyear projects. Additionally, Chevron possesses one of the healthiest balance sheets among its peers, which helps it to capitalize on investment opportunities with the option to make strategic acquisitions.

While all crude-focused stocks stand to benefit from $90+ commodity prices, companies in the exploration and production (E&P) sector are the best placed, as they will be able to extract more value for their products. In particular, we suggest exposure to small-cap, undervalued E&P players like Emerald Oil Inc. (EOX) and Jones Energy Inc. (JONE), which enjoy the benefits of crude oil price leverage.

One may also capitalize on this opportunity with the related business sector of energy equipment service providers. Our top pick in this space is Cameron International Corp. (CAM). The oil drilling equipment maker boasts of a diversified product portfolio, specialty service capabilities and proprietary technological expertise. Other positives for Cameron include a strong backlog position, growing international operations and a favorable outlook for subsea activity levels.

Further, we remain optimistic on the near-term prospects of Weatherford International plc (WFT). Going forward, there are plenty of positives for the oilfield services behemoth, including its leading position in the global market, its broad and technologically complex product/service offerings, and its growing presence in the relatively stable Eastern Hemisphere. The company is well positioned to take advantage of the multi-year expansion in the international upstream segment. The process is ongoing and is likely to gather momentum through 2014.

Within the contract drilling group, we like Nabors Industries Ltd. (NBR) and Patterson-UTI Energy Inc. (PTEN). Supported by their large and high-quality drilling fleet of rigs, together with considerable exposure to the U.S. shale bonanza, we expect the companies to sustain profitability over the foreseeable future. We believe Nabors and Patterson-UTI’s technologically-advanced units will continue to benefit from an upswing in U.S. land drilling activity and the shift to complex onshore plays that require highly intensive solutions.

China's CNOOC Ltd. (CEO) is also a top pick. CNOOC remains well-placed to benefit from the country's growing appetite for energy and the turnaround in commodity prices. In particular, the company enjoys a monopoly on exploration activities in China's very prospective offshore region in addition to having a growing presence in the country's natural gas and liquefied natural gas infrastructure. The acquisition of Canadian energy producer Nexen Inc. has further improved CNOOC’s growth profile by augmenting proven reserves by 30%, while helping it to vastly expand its holdings in Canada.

WEAKNESSES

Weak propane prices have prompted us to be bearish on independent refiner and midstream services provider Phillips 66 (PSX). We are also concerned by the company’s aggressive growth plans that require high level of capital spending, which may eventually result in reduced returns going forward.

We are also skeptical on Italian energy company Eni SpA (E). The integrated player, with a large presence in Libya, has seen its total production fluctuate in recent times, primarily due to operational disturbances at several fields in the North African nation. Additionally, Eni's upstream portfolio carries greater political risk than its peers, since it has the highest exposure to the OPEC countries. The Rome-based company has also been mitigated by a weak macroeconomic scenario in Italy and Europe that is likely to affect its performances going forward.

We see little reason for investors to own engineering and construction firm McDermott International Inc. (MDR). The company’s steep operating costs, an erratic earnings trend over the last few quarters and lack of clarity about some of the big projects have made us bearish about the firm’s near-term prospects.

Contract drilling services provider Noble Corp. (NE) is another company we would like to avoid for the time being. Apart from volatility in the macro backdrop, a sequential decline in the company’s fleet utilization and a drop in backlog continue to concern us. Moreover just 74% and 50% of available rig operating days for the remainder of 2014 and 2015 have been committed.

Lastly, we recommend against buying legacy offshore drillers like Transocean Ltd. (RIG). The most pressing concern for the group, at least in the short-term, will be oversupply in the rig market. With multinational energy biggies looking to reign in their skyrocketing capital expenses, the offshore drilling space is likely to see intense competition, as multiple firms run after a single contract.

This excess capacity, in turn, could lead to lower utilization or dayrates. As the sector looks set to enter a cyclical downturn and struggle with idled rigs, we do not see an immediate rebound in the sentiment and expect more punishing times ahead for the likes of Transocean.

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