The energy industry is caught between shale rock and a hard political place. The U.S. shale-oil boom has left the world awash in crude oil, even as many governments and climate activists press for a cleaner, greener future. Add geopolitics to the mix, including the sometimes-unpredictable moves of the Organization of Petroleum Exporting Countries and U.S. sanctions against several OPEC members, and the result has been volatile swings in oil prices and sustained pressure on energy-company shares. Today, the energy sector represents a mere 5.4% of the S&P 500 index, and that’s after a 14% gain in the stocks this year.
Just as the savviest drillers, however, can find hydrocarbons in unpromising terrain, the panelists on our 2019 energy roundtable see genuine values among the industry’s beaten-down names. In part, that’s because U.S. exploration, production, and energy-infrastructure companies have finally kicked their spending habit to focus on capital discipline, balance-sheet strength, and sustainable payouts to holders. Likewise, certain integrated oil-and-gas companies are poised to benefit as projects long in the planning finally come on-line. While our panelists don’t foresee a big surge this year in oil prices, $60 crude isn’t an impediment to success for the best-managed companies with the right business mix.
Our 2019 panel includes Helima Croft, global head of commodity strategy at RBC Capital Markets; Chris Eades, a portfolio manager at ClearBridge Investments and co-manager of the firm’s midstream energy strategies, including three publicly traded closed-end funds; David Heikkinen, founder and CEO of Heikkinen Energy Advisors, a Houston-based investment research firm; and Jonathan Waghorn, co-manager of Guinness Atkinson Global Energy fund (ticker: GAGEX), who joined the group via videoconference from London. Helima, an expert on the Byzantine world of OPEC, also participated in Barron’s 2018 energy roundtable.
This year’s roundtable was held in late February. At the time, West Texas intermediate crude, the U.S. benchmark, fetched about $57 a barrel, and Brent, the global benchmark, was trading for $65.55. On Friday, WTI was priced around $58, and Brent, at $66.50.
Barron’s : Energy stocks have been clobbered in the past five years, and the industry’s long-term outlook is questionable. Why should investors even care about this sector today?
Chris Eades: I’m an investor in midstream companies, which transport, process, and store energy commodities, chiefly in the U.S. What matters to these companies isn’t the price of oil or natural gas, but the volume of oil and gas. While the stocks didn’t do well in 2018, companies had record cash flow, and will have record cash flow in 2019. Corporate balance sheets are improving and dividend or distribution coverage is increasing. Yet valuations are at all-time lows.
Midstream companies, including C corporations and master limited partnerships, are interesting at current levels for income-oriented investors. The group’s average yield is 6.5%, compared with about 2% for the S&P 500, 3% for utility stocks, and 4% for real estate investment trusts, or REITs. Midstream companies also are better positioned from a valuation and dividend-coverage perspective, and their balance sheets are better than some utilities’ and REITs’. The asset class is out of favor for reasons that probably aren’t sustainable in the intermediate and longer term.
At what level would oil prices become a problem for midstream volumes?
Eades: If prices were to fall below $45 a barrel, there could be a material contraction in U.S. drilling. At some point, that would impact midstream-company cash flows. Below the mid-$40s, we would also have a problem with sentiment toward the stocks.
Jonathan Waghorn: The size of the energy space within the market reflects the profitability of the companies. Return on capital for 24 companies we own went from a low of 5% in 1998 to a peak of 20% in the mid-2000s. Then, as oil prices went up and up and up, the industry embarked on a massive spending cycle and returns went down and down and down. Return on capital bottomed at 2% in 2016 and is now recovering, not because of a change in the oil price, but because companies are focusing on improving returns on capital employed. As these companies get more profitable, they should start trading at a premium to book value. That’s why investors should be looking to get back into the sector.
David Heikkinen: Growth investors shouldn’t care about this space today, but relative-value and value investors should. Oil production grew so dramatically in the U.S. over the past four years that supply outpaced demand and the $100-a-barrel upcycle was killed. Then, as oil prices declined, the broad stock market took off. There is no investor muscle memory around how to make money in energy anymore. With the sector shrinking to a fraction of the S&P 500, investors haven’t had much need to look beyond the supermajors or other large-cap names.
We see opportunity because, as the industry has slowed, it has been easier to see a differentiation in asset quality, capital efficiency, and free-cash-flow yield among companies. At the same time, volume growth is matching demand more closely.
Helima Croft: I don’t focus on individual companies, but from a commodities perspective, the fourth quarter was incredibly difficult. [The price of WTI crude oil fell 38%.] Investors, and even oil ministers, tell me that one big challenge is knowing who is trading oil. Systematic trading [computerized trading, based on quantitative strategies] is thought to be causing some unusual moves. On Dec. 26, for example, oil prices rose nearly 10% in the absence of any fundamental news to justify such a move.
This year, OPEC is trying to stabilize the market by imposing production cuts. They have been highly effective. Saudi Arabia’s resolve to rebalance this market from a supply perspective is serious. Sixty-dollar oil is the new $100 for sovereign producers. The problem is, a lot of OPEC countries haven’t been able to get their fiscal houses in order in a way that allows them to adjust to a $60 oil price.
Is systematic trading becoming a bigger part of the energy market?
Croft: Yes. Banks are getting out of commodities trading. Many commodities hedge funds have closed. Oil can be traded as part of a macroeconomic strategy, but there are fewer traders these days who were brought up in the world of supply and demand. Systematic traders have stepped in.
Let’s get your oil-price forecasts for 2019.
Croft: We have $60 a barrel for WTI, and $68 for Brent crude. We have been talking about prices more in scenario-based terms. What is the downside story? That would be a global recession. The upside story is unplanned outages. We had expected Venezuela production to decline by about 300,000 barrels this year, simply because PDVSA [Petróleos de Venezuela, the state-run oil company] wasn’t paying employees or spending on maintenance and infrastructure. But putting PDVSA on the U.S. Treasury’s OFAC [Office of Foreign Assets Control] list raises the possibility of a host of sanctions that can be imposed. It makes it easier for the U.S. to compel other countries to cut back on Venezuelan imports.
Beyond sanctions, devastating blackouts in Venezuela are greatly impacting supply. And even if President Maduro leaves office, Venezuela’s recovery will be arduous. The recovery of the country’s oil industry will take years and require billions of dollars in new investment.
Eades: I agree that $60 is a good starting point, but we think a $50 to $70 band is a reasonable way of looking at the market, with volatility above and below that range in the short term. I suspect the average price in the next 10 years will be around $60.
Waghorn: Our forecast is also $60 for the year—for Brent oil. That would allow U.S. production to grow by a reasonable amount and allow some OPEC production to come back into the market. If the price goes much higher, we could see a powerful increase in production from U.S. companies. If it goes much lower, we’ll see a lack of investment.
Heikkinen: Our estimate is $50 to $52 for the next two years. OPEC has spare production capacity and, at some point, will either need a higher price or higher volumes to generate revenue. We force-rank stocks from top to bottom and have found that better opportunities arise from having a negative bias and then being pleasantly surprised, as opposed to having a positive bias that doesn’t play out so well.
While the supply side supports a floor of $50 a barrel, many generalist investors believe there is a terminal value for all oil and gas companies as the demand side ends some 15 to 30 years from now. Up to this point, I haven’t found a company making a lot of money in the alternative-energy space. Solar and wind power are 50- to 100-year-old technologies. You’re not going to change the profile of future demand by using 100-year-old technologies. New tech might break through with things like algae-based biofuels that sound interesting. Exxon Mobil [XOM] is involved in work using Crispr Cas-9 gene-editing technology on algae but it’s a long way away.
Investors might be ambivalent about oil, but President Donald Trump isn’t. He has been tweeting that OPEC should cut prices. Has this influenced the market?
Croft: It has been hugely destabilizing. OPEC and allies reversed course last summer on a longstanding deal to cut production, surging more than a million barrels of oil a day into the market in anticipation of the U.S. imposing renewed economic sanctions on Iran in November. The group had been led to believe there would be no exemptions granted for importers of Iranian oil, so they were surprised to learn subsequently that some countries got exemptions. Led by the Saudis, OPEC reversed course again at year end, cutting production. When President Trump recently told OPEC to relax, OPEC sent that message to voice mail.
I didn’t anticipate the Saudis’ U-turn last summer, but the steep slide in oil prices in the fourth quarter reminded them that there are consequences for oversupplying the market. I expect they will be reticent to do another about-face soon. The agreement in December to cut production likely will be a full-year agreement. Just look at Saudi budget numbers: This year’s budget has an official spending increase of 7%. Unofficially, it likely will be higher. Donald Trump might have an America-first policy, but the Saudis have a Saudi-first policy.
If OPEC is cutting output, will there be a call on U.S. companies to grow production in coming years?
Eades: Yes. Ten years ago, energy production in the U.S. was flat to declining. Now the U.S. is supplying 65% to 75% of incremental world demand growth in oil. Exports are a huge part of the U.S. energy story today. [Congress lifted a 40-year ban on U.S. oil exports in 2015.] Recently, the U.S. exported 2.7 million barrels a day. Exports likely will rise in the next five years, to seven million to eight million barrels a day. That will require a lot of incremental infrastructure on the pipeline and storage side. We are exporting 1.1 million barrels a day of natural-gas liquids, which will probably rise to four million barrels in the next five years. In natural gas, too, the U.S. has shifted to being a net exporter. Exports of liquefied natural gas went from zero in 2015 to 2.9 billion cubic feet a day, and are probably headed to 7.5 Bcf in the next three or four years. The runway for growth is phenomenal, and it isn’t baked into stock prices at current levels.
Where are the best midstream values?
Eades: In 2010, when we launched our first midstream fund at ClearBridge, the best companies from an investment perspective were those that grew their distributions or dividends fastest. Today, the winners are those that retain enough cash flow to fund their capital-spending programs.
Chris Eades’ Picks
Beyond valuation, I look for eight things: no incentive distribution rights [IDRs] paid by a master limited partnership to a general partner; high dividend/distribution coverage ratios; self-funding (or close to it); balance-sheet leverage below 4.5 times debt to year-end 2019 Ebitda [earnings before interest, taxes, depreciation, and amortization]; exposure to the Permian Basin and/or Marcellus formation [the Permian is a large shale-oil producing region in Texas and neighboring states; the Marcellus is in the Eastern U.S.]; exposure to growing U.S. energy exports; organic growth projects driving visible cash-flow growth; and fee-based cash flows with limited commodity-price exposure.
I’ve got five recommendations. Energy Transfer [ET], a pipeline and storage company, has Permian, Marcellus, and export exposure. The stock yields 7.9%; the company pays no IDRs and self-funds capital spending. Distribution coverage is 1.8 times distributable cash flow. Balance-sheet leverage will be 4.3 times Ebitda at year end. Capital spending will peak in 2019, as several large projects come into service. With lower capital expenditure in 2020 and growing cash flows from new projects, Energy Transfer likely will increase its distribution and/or implement a stock-buyback program. The stock trades for $15, and I see fair value at $20.
Enterprise Products Partners [EPD] has crude-oil, natural-gas, and NGL infrastructure assets with exposure to the Permian and growing U.S. exports. The stock yields 6.2%. The company has no IDRs and is close to self-funding capital spending. It has one of the best balance sheets in sector, with a debt-to-Ebitda ratio of 3.5 times likely by year end. A $6 billion backlog of projects in the Permian will drive cash-flow growth over the next several years. A potential offshore crude-export terminal and another PDH [propane dehydrogenation] plant could further drive growth. The stock trades at $28, and I see fair value at $32.
What else makes the cut?
Eades: Kinder Morgan [KMI] is natural-gas-focused, with exposure to both the Permian and exports. With an expected increase in its dividend this quarter to 25 cents a share, it yields 5.2%. The company has no IDRs, 2.2 times dividend coverage, and balance-sheet leverage that should decline to 4.3 times by year end. A key component of growth will be two large natural-gas pipelines running from the Permian to the Texas Gulf Coast. The stock trades for $19 and could trade up to $24.
Plains All American Pipeline [PAA] is crude-oil focused, with exposure to the Permian. It yields 5.1% and has no need to issue equity to finance its backlog. It has a distribution coverage ratio of 1.9 times and no IDRs. Debt will hit 3.7 times Ebitda by year end. Growth over the next few years will come from three large crude-oil pipelines from the Permian to the Texas Gulf Coast, and from continued expansion of Plains’ crude-oil gathering system in the Permian. Distribution growth is likely to resume in 2019. The stock trades at $23. Fair value is closer to $28.
Williams Cos. [WMB] is natural-gas focused, with exposure to the Marcellus. It yields 5%. Williams has no IDRs, and is close to self-funding capital spending. It has a dividend-coverage ratio of 1.7 times, and should have 4.4 times debt to Ebitda by year end. Williams’ biggest asset is the Transco pipeline, where expansion projects will push throughputs from 15 Bcf per day a year ago to an expected 19.5 Bcf per day in 2021. The stock trades at $27 and could have upside to $32 over the next 12 months.
This basket of stocks generated a 10% total return over the past 12 months, compared with 4% for the Alerian Midstream Energy Index. I expect the stocks’ outperformance to continue.
Jonathan, give us the view from Europe.
Waghorn: Investors have lost interest in recent years due to excess U.S. supply and OPEC’s production strategy in 2014. [The organization couldn’t agree to cut output and oil prices plummeted.] There have also been concerns about the demand story. There is a real interest in Europe in vehicle electrification. In Norway, 45% of new-car sales are electric; government subsidies have made that happen. Sustainability and decarbonization are also big issues in Europe. Asset allocators say they are pressured by investors who want to consider green portfolios.
In addition, this industry must put more money to work every year to offset production declines from existing projects. Companies operating in non-OPEC countries (other than the U.S. onshore) invested heavily until 2014-15, and projects associated with that spending are only now commencing production. Thereafter, the outlook is for diminishing growth of new projects. The same is true of OPEC. It will also get increasingly difficult for U.S. shale producers to deliver growth.
Which stocks look most attractive to you?
Waghorn: It is difficult to find opportunities in gas. U.S. supply is abundant, and prices are low. [Natural gas futures settled on Friday at $2.80 per million British thermal units.] Globally, there aren’t many good pure plays in liquefied natural gas, and valuations get rich. So our bias is toward oil. We like companies with good economic returns, whether through high free-cash-flow yields or growth plus yield. We own four of the five supermajors— Royal Dutch Shell [RDS.A], BP [BP], Total [TOT], and Chevron [CVX]—and some large integrated companies. We have an equal-weight portfolio of 30 stocks.
Jonathan Waghorn’s Picks
Shell’s American depositary receipts trade for about $64, or just under six times enterprise value to 2019 Ebitda. The five-year average is seven times. The stock yields 6%. The company has improving returns on capital employed and an increasing share of production from natural gas. Canada’s Suncor Energy [SU], an oil-sands producer, is slightly more risky. It also trades for six times 2019 EV/Ebitda. The company got its house in order as the oil price fell, and now delivers a 3.5% dividend yield and a 10% free-cash-flow yield. We see about 5% top-line production growth and a well-supported balance sheet. At a recent $34, Suncor is pricing in a long-term oil-price expectation of about $54 a barrel Brent.
PetroChina [PTR], an arm of state-owned China National Petroleum, is an integrated oil company with a natural-gas focus. China’s economy has been slowing, and Chinese stocks are under pressure. The company’s American depositary shares trade for 3.5 times enterprise value to 2019 Ebitda, and price in expectations for about $50 Brent. The company has a 4.5% dividend yield, and a 10% free-cash-flow yield. PetroChina is on its knees at the moment. Expectations are low.
We also like Noble Energy [NBL], a U.S. exploration-and-production company that will start producing at year end from an enormous Mediterranean gas field, off the coast of Israel. When production ramps up in 2020 and 2021, you could get 30% growth volumes. At $23, you’re paying 3.5 to four times EV/Ebitda. Lastly, Halliburton [HAL] is the second-largest global oil-services company. It offers a good-quality mix of business lines, balance-sheet strength, and exposure to growth in U.S. shale-oil activity. There’s some near-term downside risk to consensus earnings as the U.S. shale system slows down in early 2019, but with the stock trading around $30 there is potential for earnings to recover and the share price to react favorably.
How do you view the other supermajors?
Waghorn: We don’t own Exxon Mobil due to valuation. At around $78, it trades for 8.2 times enterprise value to 2019 Ebitda. Chevron trades for six times. They have similar businesses, and have recently announced large investments in the Permian Basin. Chevron is in a sweet spot of delivering strong cash flows from a range of new projects and therefore offers a higher free-cash-flow yield than Exxon.
As a group, the supermajors offer attractive dividend yields and strong free-cash-flow generation. For 2019, the average dividend yield is around 4.9%, versus a five-year average of around 4.1%. At $60 per barrel Brent, we expect that the group will easily cover dividend payments and still have spare free cash flow to buy back shares or pay down debt.
David, which stocks are in your top tier?
Heikkinen: We also like Noble Energy, which will have a 5% to 6% free-cash-flow yield in 2020. It isn’t trading that way because people don’t fully believe the company will be able to produce gas in Israel and in the regional market of Egypt. Noble’s new team in Egypt should line up contracts, which, combined with purchasing and testing an existing but out-of-commission pipeline into Egypt, should enable new volumes and higher realized pricing. We believe that Noble can trade into the $30s as the market looks toward 2020.
David Heikkinen’s Picks
David Heikkinen’s Pans
We see some of the best value in companies with Permian potential. Multiples of many companies in the Midland basin [a section of the Permian] have been compressed. We rate Pioneer Natural Resources [PXD] and Diamondback Energy [FANG] favorably, followed by Parsley Energy [PE], in that order. Each has reset growth expectations and that lowered estimates. They are now en route to a widespread string of estimate beats and raises, and better price realizations in 2020 as Permian pipelines come online and production ramps. Pioneer has the deepest inventory, driving a net asset value of $200 a share. It trades for less than seven times 2020 estimated EV/Ebitda. Parsley trades for 5.4 times, and Diamondback, for 5.2 times. All are on our focus list.
Encana [ECA] also offers an attractive valuation, free cash to buy back shares, and growth potential. It recently bought Newfield Exploration, a big operator in Oklahoma, but the market hates the deal as Newfield’s primary assets are in the out-of-favor Stack/Scoop play. The stock has sold off, leaving the company’s Texas assets trading at a big discount to peers. Encana has a headwind, as attractive 2019 oil-price hedges are rolling off into 2020.
Which stocks rank low in your ratings?
Heikkinen: The market has priced Hess [HES] as though free cash flow will grow to $6 billion a year in 2025. But 2025 is a long time from now. The company has considerable leverage to deepwater production near Guyana, but historically, as oil companies begin to generate Ebitda from major projects, their stock valuations get compressed. At a recent $58 a share, the market is underwriting meaningful resource discoveries in Guyana. But the story won’t hold as Hess starts bringing those projects online in the next two years. Hess is ahead of itself on valuation at more than 10 times Ebitda.
Oilfield-services companies have been trying to keep up with the shale revolution. They’ve spent excessively, and returns have started to fall. Second-half 2019 earnings estimates for pure-play small- and mid-cap oil-services companies are too high, and we expect them to suffer as estimates get cut. On the other hand, shares of integrated oil-services companies such as Baker Hughes [BHGE] and Schlumberger [SLB] have probably fallen too much. I favor Schlumberger and Baker Hughes a bit more than Halliburton because of their international exposure. Schlumberger offers a dividend yield of almost 5%, and Baker Hughes, almost 3%. Both trade well below historical multiples.
I would short fracking-sand companies, such as Hi-Crush Partners [HCLP] and U.S. Silica Holdings [SLCA]. They are effectively mining dirt. It is a low-margin business, and the U.S. is oversupplied. There is no barrier to entry. The charts look awful, but their estimates need to fall, and multiples should compress further.
Among land drillers, we see opportunity in Helmerich & Payne [HP]. The stock has underperformed the VanEck Vectors Oil Services exchange-traded fund [OIH] by more than 9%, and has more estimate stability and an improved free-cash-flow outlook following a 23% cut to capex. The company’s more-than-5% dividend yield is secure, and their superspec rig fleet will take market share in the shales as more-complicated, longer horizontal wells are drilled. Like Chris, we like Enterprise Products Partners and Plains All American for their exposure to the Permian and exports. Conversely, Targa Resources [TRGP] and EnLink Midstream [ENLC] tend to be more capital-intensive and aren’t generating the cash flow that competitors have. Both are in the bottom tier on our list.
What is one big theme that energy investors should focus on this year?
Heikkinen: The business’ increasing stability allows investors to differentiate quality. Companies have fixed their balance sheets; they are generating free cash flow, and there is some yield component. Valuations are low. There is probably upside to free cash flow, capital efficiency, and the oil price. Thus, there is upside bias from an investment perspective over the next few years.
Waghorn: I, too, urge investors to pay attention to this sector, certainly while major energy companies are talking about capital discipline, cost controls, and free-cash generation. This industry doesn’t need $100 oil to be acceptably profitable again. With equities pricing in a long-term price expectation around $52 a barrel, that’s an opportunity.
Eades: Publicly held midstream assets are trading at lower cash-flow multiples than assets changing hands in the private-equity market. This is upside-down, and probably not sustainable. Consolidation might be the catalyst for midstream companies to shake off their malaise. Also, don’t rule out private-equity buyers. Blackstone [BX] and KKR [KKR] recently bought midstream energy assets. That’s a signal that some midstream assets are cheaper in the public market than in private markets.
Croft: President Trump essentially got OPEC to move 180 degrees on production policy, which had material implications for energy prices. We expect him to continue to try to bend the organization to his will. That’s where the Nopec bill [No Oil Producing and Exporting Cartels] becomes important. It would apply antitrust legislation to OPEC, declaring it a cartel, which could make it subject to government lawsuits. Presidents have vetoed Nopec in the past, but Trump said in 2011 that he would support it. Then again, he is also strongly supportive of Saudi Arabia. We expect the Saudis to lobby heavily against the bill. Defense and aerospace companies will lobby against it, too, because they supply OPEC countries with weapons. Quietly, U.S. producers will probably tell Trump this is a bad idea. People keep writing OPEC’s obituary, but OPEC plays a critical role in putting a floor under oil prices.
Duly noted, and thank you, all.
Write to Lauren R. Rublin at firstname.lastname@example.org