The improving economic scene — both here in the U.S. as well as worldwide — and the continued unrest in producing countries had been the main driver of the oil rally that saw the commodity zoom past the $110 per barrel level last month.
However, apprehensions about soaring U.S. crude stocks — currently at their highest level in two years — and worries that China’s tightening monetary policy in response to inflationary pressures may bring down its growth momentum, have been weighing on investor sentiment, weakening oil prices to less than $100 a barrel.
But far too many factors weigh on oil prices — from OPEC decisions and geostrategic tensions to the value of the U.S. dollar and seasonal variables — to definitively size up each one of them for their respective impact on prices.
As per the latest release by the Energy Information Administration (EIA), crude supplies are higher than the year-earlier level and are above the upper limit of the average for this time of the year. This has led to demand concerns against a backdrop of persistently slow job growth. At the same time, global oil consumption is expected to grow at a healthy rate this year, buoyed by the continued demand strength in the major emerging market economies.
As such, crude oil’s near-term fundamentals remain patchy, to say the least. The long-term outlook for oil, however, remains favorable given the commodity’s constrained supply picture.
According to the EIA, world crude consumption grew by an estimated 2.2 million barrels per day in 2010, to 86.6 million barrels per day, which more than made up for the losses of the previous 2 years and surpassed the 2007 level of 86.3 million barrels per day (reached prior to the economic downturn). One might note that global demand for 2009 was below the 2008 level, which itself was below the 2007 level — the first time since the early 1980’s of two back-to-back negative growth years.
The agency added that average global consumption growth over the next 2 years is likely to return to rates seen before the onset of the global downturn in 2008. EIA, in its Short-Term Energy Outlook, said that it expects the current economic recovery to contribute towards global oil demand growth of 1.4 million barrels per day in 2011 and 1.6 million barrels per day in 2012. However, the EIA’s most recent demand growth forecast for 2011 is 120,000 barrels per day lower than in the earlier version, as the agency sees high crude prices cutting into consumption.
Recently, the Paris-based International Energy Agency (IEA), the energy-monitoring body of 28 industrialized countries, also trimmed its 2011 world oil demand outlook, citing the impact of persistent high prices and weaker economic growth for developed economies. IEA predicts that global oil demand would increase by 1.5% (or 1.3 million barrels per day) annually, reaching 89.2 million barrels a day in 2011 from last year’s 87.9 million barrels a day. The energy agency’s current estimate for 2011 is lower by 190,000 barrels a day from its last report, issued in April 2011.
However, the third major energy consultative body, the Organization of the Petroleum Exporting Countries (OPEC) — the oil cartel that supplies around 40% of the world’s crude — forecasted marginally stronger-than-previously-anticipated global oil demand in 2011. In its latest monthly oil report, OPEC said it expects world oil demand to grow by 1.4 million barrels per day in 2011, reflecting an upward revision of 20,000 barrels a day over the previous assessment. The organization maintained that oil supplies remain balanced despite the political crisis in the North African and Arab countries, as its members and other producers pump more crude.
We expect crude oil to trade in the $100-$110 per barrel range in the near future, supported by the continued tightening of world oil markets. But this does not mean that we will not see any short-term pullbacks. On the whole, we expect oil prices in 2011 to be higher than 2010 levels, but remain significantly below 2008 peak levels.
Though the favorable weather this winter and production freeze-offs in January and February erased the hefty surplus over last year’s inventory level and the five-year average, the specter of a continued glut in domestic gas supplies still exists, with storage levels remaining close to their five-year average.
A supply glut has pressured natural gas futures for much of 2010, as production from dense rock formations (shale) — through novel techniques of horizontal drilling and hydraulic fracturing — remain robust, thereby overwhelming demand.
As per the U.S. Energy Department, domestic gas output increased significantly in 2010, by an estimated 2.4 billion cubic feet per day, or 4.1%, as production declines in Alaska and the Gulf of Mexico were offset by a healthy increase in lower-48 onshore volumes. Storage amounts hit a record high of 3.840 trillion cubic feet in November, while gas prices during the year fell 21%.
Looking forward, EIA expects average total production to rise by 2.3% in 2011 and by 0.9% in 2012, while total natural gas consumption is anticipated to grow by 0.5% this year and by 0.7% during the next year.
We believe these supply/demand dynamics — the projected lower production growth and higher consumption growth — will lead to the strengthening of natural gas prices in 2012.
But until then the weak fundamentals are going to continue to weigh on natural gas prices, translating into limited upside for natural gas-weighted companies and related support plays.
In this current turbulent market environment, we advocate the relatively low-risk energy 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), ExxonMobil Corp. (XOM) and Total SA (TOT).
The current oil price environment should also benefit producers, particularly those international players having attractive growth opportunities in their home markets. Two such standout names are China’s CNOOC Ltd. (CEO) and PetroChina Company Limited (PTR), both of which remain well-placed to benefit from the country’s growing appetite for energy and the turnaround in commodity prices.
CNOOC 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 LNG infrastructure. On the other hand, PetroChina — one of two Chinese integrated oil companies — is poised to capitalize from the country’s impressive economic growth that has significantly increased its demand for oil, natural gas and chemicals.
We are also positive on natural gas producer and pipeline firm The Williams Companies Inc. (WMB). We like the company’s strong business mix, attractive growth opportunities in its low-risk upstream model and relatively stable fee-based midstream services. We also think that the just-concluded consolidation program will allow Williams to simplify its structure, pay down debt, drive growth and unlock value for shareholders.
Furthermore, the company’s proposal to split into two separate entities is expected to be long-term accretive. Higher natural gas liquids (NGL)/oil prices and improved olefin margins add to the positive sentiment.
Another company we like is independent energy exploration and production firm Cabot Oil and Gas (COG). Notwithstanding its high natural gas exposure, the growth momentum from the company’s drilling efforts should help generate steady volume increases going forward. We also like Cabot’s relatively low risk profile and longer reserve life asset base. Following the recent capital infusion of over $200 million and strong operating results, we believe that the outlook at Cabot has improved significantly.
Onshore contract driller Patterson-UTI Energy Inc. (PTEN) is also a top pick. The company, which had a heavy spot market exposure, was hit badly by the financial crisis with operators tending to release land rigs to preserve cash. However, Patterson-UTI Energy has recovered almost all its lost market share, benefiting from its growing premium land rig fleet and the current boom in pressure pumping services (an umbrella term used to describe a number of vital services performed on new and existing wells).
Buoyed by the favorable trends in the refining sector, we are more optimistic on the industry than we were 12 months ago. Uptick in economic activity overseas (mainly in China and India) and prospects for higher fuel demand in the U.S. are likely to push 2011 industry margins higher than last year’s levels. Against this backdrop, we are particularly bullish on Valero Energy Corp (VLO) and Tesoro Corp (TSO).
We are bearish on Switzerland-based oil services firm Weatherford International Ltd. (WFT) following the company’s sloppy first quarter on the back of continued weakness in international markets. A string of lackluster results and the recent disclosures of tax accounting mistakes have made investors skeptical regarding the company’s earnings outlook.
China Petroleum and Chemical Corporation, or Sinopec (SNP), the second largest crude oil and natural gas producer and the largest refiner and marketer of refined petroleum products in China, is another company we would like to avoid for the time being. We remain concerned about Sinopec’s exposure to the heavily regulated downstream sector. Though Chinese oil companies are able to charge close to market prices for their crude oil (though heavily taxed), the government plays a major role in refined-product pricing (particularly gasoline and diesel) to control inflation.
Lastly, we continue to be skeptical on offshore drillers, given the fallout from the Macondo incident and the high number of rigs available to the market. In particular, we take a pessimistic stance on Transocean Inc (RIG) because of its active involvement in the Gulf of Mexico oil spill. For Transocean, the operator of the Deepwater Horizon drill rig, earnings are likely to suffer from the uncertainty in the near-to-medium term outlook for deepwater drilling.