Select U.S. Energy Stocks Poised to Benefit from Crude Oil Rebound Key Takeaways: fstagnating f production combined with strongerthan-expected global demand could soon lead to a market rebalance. fflack of OPEC spare capacity and an inability of non-opec suppliers to ramp up production will require U.S. exploration and production companies (E&Ps) to balance the global market. ffbest in class U.S. E&Ps require $65 per barrel crude oil in order to increase activity, with higher-cost producers and those in the Bakken region requiring $70+ per barrel. Following a more than $60 per barrel decline over nine months, the price of West Texas Intermediate (WTI) crude oil has stabilized. WTI has retraced about $20 per barrel of its historic decline through mid-may, and recent data indicates that oil supply and demand are starting to rebalance. While global oil production is stagnating, demand is beginning to surprise to the upside. Should this rebalancing continue, U.S. producers stand to benefit from an improving commodity price environment. Exhibit 1: U.S. Oil Rig Count (June 6, 2014-May 29, 2015) 2,000 1,500 # of Rigs 1,000 646 Rigs Operating May 29, 2015 500 0 Jun. 2014 Aug. 2014 Oct. 2014 Dec. 2014 Feb. 2015 Apr. 2015 Source: Baker Hughes.
ENERGY UPDATE Low (sub-$55 WTI) oil prices have caused U.S. production to decline and rig counts to fall (Exhibit 1) after years of world-leading growth, while global demand is outpacing expectations after disappointing in 2014. At the current trajectory, ClearBridge projects that the market will be undersupplied in 2016. In order to avoid a shortfall in supply, U.S. exploration and production activity will need to gradually rise. The pace of the return of activity will govern the oil price trajectory, which we continue to believe will ultimately rise toward the marginal cost of around $75+ per barrel. Shares of E&P and oil services companies have bounced off the bottom with oil prices and we expect volatility to pick up due to a handful of emerging, near-term risks. These include the timing and magnitude of an increase of activity in the U.S., record inventories, as well as the timing and extent of the removal of Iran sanctions an event which could cause oil to revisit the $50-55 range. Despite these issues, the risk-reward of the energy sector into 2016 and beyond is positive, and we recommend maintaining exposure to the sector and adding on weakness. The last 12 months have provided valuable insights into global supply and demand curves: Sub-$55 WTI is unsustainably low and causes sharp and deep cuts in U.S. activity levels. For U.S. E&Ps, the commodity price necessary to bring on new supply is a function of asset quality and execution. Non-OPEC ex-u.s. production is unable to grow, even with $100 oil prices. At sub-$80 oil, long lead time projects are being cancelled, causing a fall-off in new supply into 2018 and beyond. OPEC has raised production, but ex-iran, the cartel has limited spare capacity. We have also noticed that demand response starts to show up at sub $80 oil. Call on the U.S. to Close Demand Gap Given the impending supply/ demand imbalance, we expect the U.S. rig count will start rising as the call on the U.S. increases. With demand growth bouncing back to trend levels, coupled with the inability to grow supply in a sustainable way internationally, the call on the U.S. will rise. We estimate that roughly $75/bbl WTI will be required to support sufficient activity levels in the U.S. to meet oil demand growth. Currently, there are 646 drilling rigs operating in the U.S. down from a peak of 1,931 and we estimate that roughly 1,500 rigs will be required to support adequate production levels. The U.S. rig count should start to rise in the second half of 2015, requiring higher oil prices in 2016 and 2017 in order to accommodate increased activity levels. As oil bounces back toward marginal cost, on a full cycle basis, there is attractive upside to normalized valuations for energy share prices. The shares have moved up from the trough levels in the first quarter, but we should expect to see increased volatility as the market searches for the correct pace of activity resumption globally. In the rising crude price environment, we expect the lower-beta oil majors to underperform the higher-beta E&Ps and the oil services names. Oil services stocks are trading at relatively low price-to-tangible book multiples, while E&P names have attractive upside to their net asset value. However, with earnings-based multiples having expanded to near prior recovery levels, earnings growth trajectory will start to matter again, suggesting that the next leg of the stocks will be driven by the rig count and oil price recovery rather than multiple expansion. Considering that the earnings of these companies are depressed relative to history, there is substantial running room for growth toward normalized earnings. Based on normalized estimates, service names are trading at 5.5X EV/EBITDA vs. an average of 7.8X. Exhibit 2: Non-OPEC Ex-North America Production (2002-2015E) Non-OPEC Production ex-na Fell in 2011/2012 and Remains Low Despite All-Time High Investment and Activity (Rig Count) YoY Change in Liquids Production (mb/d) 1.5 1.0 0.5-0.5-1.0-1.5 2002 2003 2004 0.4 0.3 2005 2006-1.3 2007-0.7 2008 2009 0.3 2010-0.3 2011-2012 YoY Change in Non-OPEC Production Ex-North America We anticipate further downside risk given capex cuts 2013 0.1 2014-0.2 2015E 2
Data Pointing to Production/Supply Declines Reaction to lower WTI has been swift and steep among U.S. E&Ps. Overall U.S. oil rig count is down 59% from its October peak as balance sheets come under stress. With oil drilling activity down significantly, U.S. crude oil production is peaking and expected to deteriorate in the near term. Production guidance from the E&Ps on first quarter 2015 calls and our discussions with these companies point to declining production in the second and third quarter. Production is expected to start increasing in the fourth quarter due to drilled but uncompleted wells coming on-line and a higher rig count. There is a six-month lag between adding rigs and seeing production, suggesting that we are likely to see rigs going back up in the near term. Companies with the best acreage and best balance sheets are expecting to raise activity based on sustaining a $65 price level. Higher cost players in the Bakken, however, are taking a more cautious stance. Producers there will require a stronger price signal to revive drilling, likely a sustained $70+ per barrel level. The low cost structure the U.S. E&Ps are enjoying now is going to move higher as soon as they decide to increase activity, raising the threshold pricing needed to hold higher activity levels. Outside of the U.S., the oil rig count is down 1 from the peak. Meanwhile, longer lead time deepwater projects are being deferred as oil and gas companies look to reduce costs as free cash flow suffers. Considering that non-opec ex-north America production did not grow even with $100 oil (Exhibit 2), the cut in spending does not bode well for future production. OPEC production has increased, but its ability to boost production further is likely limited without Iran. OPEC spare capacity has declined to 3.4 million barrels per day (Exhibit 3), according to the International Energy Agency (IEA). Adjusting for 0.6 million bbl/d of Iranian production coming back, that leaves spare capacity at only 2.8 million bbl/d a low level last seen in 2006-2007 when oil prices rose rapidly. Saudi Arabia has increased production to 10.1 million bbl/d but with only 12 million bbl/d capacity. Further increases could result in a pickup in decline rates and an elimination of spare capacity, leading to a failure to respond to any supply shocks. The Financial Times reports that with higher expenditures tied to social spending and a war in Yemen, Saudi Arabia s roughly $745 billion in cash reserves declined by in February and March. Iraq production has been ramping up, but the rig count is collapsing as the government diverts capital to fighting ISIS and as foreign oil companies are reducing investment. Libyan production is running 3 to 40% below its third quarter 2014 levels, and while its ability to ramp up is unknown, we would note that oil service activity has ceased in the country. Global Demand on the Upswing Global demand growth is improving, bouncing up to at least million bbl/d year-over-year growth in the first quarter its highest level since mid-2013 (Exhibit 4). This follows a very disappointing 2014, when demand grew by only 600,000 bbl/d. We are seeing solid improvement broadly in the U.S., Europe, and Asia. U.S. demand was up YoY in Exhibit 3: OPEC Spare Capacity (2001-2015E) Spare Capacity (mn bbl/d) 7 6 5 4 3 2 1 0 7% 6% 3% 4.6 6.3 4.0 2.4 1.5 2.0 3.4 4.0 6.6 5.8 4.6 3.7 4.6 4.1 3.4 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015E 9% 7% 6% 3% 1% 0% Spare Capacity as % of Demand Spare Capacity Spare Capacity as % of Demand 3
ENERGY UPDATE the first quarter after holding flat in 2014, per the IEA. But that figure may be underestimating demand as the weekly Department of Energy statistics point to a YoY demand increase, driven by gasoline (+), jet fuel (+9%) and distillate (+). Miles driven were up 3% YoY in the October to February period and are 3. higher year-to-date. Chinese demand has also been surprisingly strong to start the year. Demand was up 3% in the first quarter, as reported by the IEA, a consistent rate of growth from 2014 despite fears that China is slowing down. In fact, we are seeing April data that suggests that Chinese apparent demand was +7% YoY and may have been up as much as 6% year-to-date. Demand has risen for both gasoline and diesel. Demand in Europe, which has been falling every year since 2008, is finally showing signs of life. First quarter growth was an exceptionally strong YoY and the IEA is actually revising demand upward, which is partially a function of cold weather but could also reflect central banks QE efforts. It now appears that European demand may be flat to slightly higher in 2015, reversing a seven-year decline trend. Conclusion The price of WTI has bounced off the bottom and could continue to grind higher as macro conditions become more supportive of renewed growth in U.S. drilling activity, even though we are mindful of near-term transient risks. Given the sharp declines in U.S. and global production capacity combined with surprisingly strong demand trends taking hold in the U.S., China and Europe, the market is overcoming recent oversupply and calling for a return to production growth. We believe dwindling spare capacity in OPEC and the lack of financial flexibility for international producers to increase production will require the call on the U.S. to rise in order to balance supply and demand in 2016 and beyond. We anticipate that WTI will need to reach $75 per barrel for this scenario to play out and that U.S. E&Ps and oil services companies stand to benefit from a recovery toward normalized earnings. Exhibit 4: Year-over-Year Global Demand Growth (1Q13-1Q15) 1.8 YoY Percentage Change (%) 1.6 1.0 0.8 0.6 0.4 1.5 1.1 1.1 0.3 0.5 0.7 0.2 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 YoY Change in Demand 4
About the Authors Dimitry Dayen, CFA Director, Senior Research Analyst for Energy 10 years of investment industry experience Joined ClearBridge in 2014 Member of the CFA Institute Member of the New York Society of Securities Analysts BA in Economics from New York University Tatiana Thibodeau Director, Senior Research Analyst for Utilities 16 years of investment industry experience Joined ClearBridge in 2005 MBA in Finance and Accounting from New York University BA in Philosophy and Foreign Literature from Turkmen State University - Honors Degree ClearBridge Investments 620 8th Avenue, New York, NY 10018 ClearBridge.com Past performance is no guarantee of future results. Copyright 2015 ClearBridge Investments. All opinions and data included in this commentary are as of May 28, 2015 unless noted otherwise and are subject to change. The opinions and views expressed herein are of the ClearBridge Investments Energy portfolio management team and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information. 5