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.
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.
Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Exclusive Interviews page.
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.