Crude Oil
The improving economic scene, both here in the U.S. as well as worldwide, is the main driver of the current oil rally that has seen the commodity settling around the $80 per barrel level. But high levels of product inventories (particularly gasoline), along with still higher supplies, will limit any sustained crude gains, in our view. But way 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.
In its latest release, the Energy Information Administration (EIA) reported a higher-than-anticipated increase in crude stockpiles, which rose by 3.7 million barrels for the week ending Jan 8. This follows a 4-week trend of a steady decline in supplies, which slid by approximately 14 million barrels during the period, fueled by cold weather. At 331.0 million barrels, crude supplies remain 4.4 million barrels above the year-earlier level and above the upper limit of the average for this time of the year. As such, crude oil’s near-term fundamentals remain weak, to say the least.
Last week, the EIA released its ‘Short-Term Energy Outlook.’ It stated that world crude 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.
However, the agency also provided some positive news in this otherwise bleak supply-demand picture. According to EIA, the decline in oil demand bottomed out in the middle of 2009, as the world economy began to rebound in the later half of the year. The agency expects this recovery to continue in 2010 and 2011, contributing to global oil demand growth of 1.1 million barrels per day and 1.5 million barrels per day, respectively.
Recently, the Paris-based International Energy Agency (IEA), the energy-monitoring body of 28 industrialized countries, also affirmed its global oil demand forecast for 2010, citing growth in developing economies, led by China. IEA predicted that oil demand will average 86.3 million barrels a day in 2010, or 1.4 million barrels a day more than in 2009.
Our view is that oil should be able to hold onto its recent gains and consolidate around current levels, provided this favorable economic view remains in place. But this does not mean that we will not see any short-term pullbacks. On the whole, we expect oil prices in 2010 to be higher than the 2009 levels, but remain significantly below the 2008 peak levels.
Natural Gas
The commodity has fared extremely well during the past month (Dec ’09), giving returns of over 35% on the back of sustained inventory drawdown. Natural gas prices ended 2009 at about $5.50 per million Btu (MMBtu), up more than 100% from their September 2009 lows.
Nevertheless, we are not fully convinced about the sustainability of natural gas’ recent gains, as the specter of a continued glut in domestic gas supplies (storage levels remain 4.4% above their five-year average) still weighs and the inventories remain higher compared to averages for this time of year. This translates into limited upside for natural gas-weighted companies and related support plays.
While drilling has declined significantly over the past 12 months, production has not slowed that much. The bulk of the decline in rig count has occurred in vertical gas drilling rigs, which drill straight down in search of conventional gas deposits. The number of vertical drilling rigs has dropped over 42% since the beginning of 2009.
On the other hand, horizontal/directional rig count (encompassing new drilling technology that have the ability to drill and extract gas from dense rock formations, also known as shale formations) have fallen at a much slower pace, with rig count down just 6% from the Jan 2009 levels. Consequently, gas production from the highly prolific shale plays have continued to surge, fueling the glut in domestic natural gas volumes over the last few years.
As a result, there is a feeling that more cuts in rig count may be required to bring the oversupplied market into equilibrium, particularly with gas inventories at fairly high levels and industrial demand still down sharply due to a lackluster economy.
OPPORTUNITIES
The strengthening oil price environment should benefit producers, particularly those international players having attractive growth opportunities in their home markets. Two such standout names are Brazil’s Petroleo Brasileiro S.A. (PBR), or Petrobras, and China’s PetroChina Company Limited (PTR), both of which remain well-placed to benefit from the country’s growing appetite for energy.
Petrobras, the largest integrated energy firm in Brazil, stands to benefit from the continuous demand growth in Brazil (expected to outperform developed countries in the next few years). Additionally, we expect the company’s expertise in deep-water operations, huge recent discoveries (which could double its resource base), and the growing domestic refined products market to fuel its medium-term earnings outlook.
China’s impressive economic growth has significantly increased its demand for oil, natural gas and chemicals. This growth momentum presents attractive opportunities for industry players that can meet the country’s fast-growing energy needs. Being one of the two integrated oil companies in China, PetroChina is well-positioned to capitalize on these favorable trends.
Within the oilfield services group, we are positive on companies such as Cameron International (CAM) that derives about two-thirds of its revenue from outside North America, thereby playing an offsetting role to the relatively soft U.S. drilling scene. Cameron’s earnings outlook is improving, with estimates for this year and next on the rise. A healthy backlog of $5.1 billion, coupled with Cameron’s strong financial health, growing international operations, and the still favorable outlook for the deepwater offshore markets should help the company outperform its peers.
WEAKNESSES
We continue to feel strongly that industry players in the servicing and drilling ends of the business with substantial natural gas-focused and North America-centric operations should be avoided. A major sub-sector that fits that description is the onshore drillers. While we currently don’t have any Underperform rated stocks in this group, we remain skeptical of land drillers like Nabors Industries (NBR) and Patterson-UTI Energy (PTEN). Although we expect the land rig count to continue with its steady rise during 2010, the large amount of excess capacity in the sector will weigh on dayrates and margins well into the year.
We also maintain our cautious view on oil refiners, with utilization rates staying at historic lows for this time of the year amid too much supply of petroleum products in the face of sharply lower demand. As such, we have a bearish stance on companies like Sunoco Inc. (SUN), Tesoro Corp. (TSO), Valero Energy Corp. (VLO) and Western Refining Inc. (WNR), given that the overall environment for refining margins is likely to remain poor. The sharply lower refinery utilization (at just 81.3% of capacity) provides enough evidence that refineries are cutting back on production because the economy is still struggling on the demand side.
