OUTLOOK

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 less-than-anticipated increase in crude stockpiles, which rose by 800,000 barrels for the week ending October 23. However, current crude oil stocks, at 339.9 million barrels, still remain 9% above the year-earlier level as well as above the upper limit of the average for this time of the year. As such, crude oil’s near-term fundamentals remain dismal, to say the least.

At current projections, world crude demand for 2009 is expected to be below last year’s level, which itself was below the 2007 level — the first time since the early 1980’s of two back-to-back negative growth years.

Last month, the Paris-based International Energy Agency (IEA) provided some positive news in this otherwise bleak supply-demand picture. The energy-monitoring body of 28 industrialized countries hiked its global oil demand forecast for both this year and 2010 by 200,000 barrels per day and 350,000 barrels per day, respectively, citing higher-than-expected consumption in Asia and the Americas.

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 overall picture remains particularly weak for natural gas, whose inventories have recently hit a new record high of 3.76 trillion cubic feet (Tcf) and is threatening to test the maximum capacity of 3.89 Tcf. Continued strong domestic production (from a number of unconventional natural gas fields) and recessionary consumption (due to the economic downturn), particularly in the industrial sector, are at the core of the commodity’s current woes.

Natural gas prices rallied earlier last year, reaching over $13 per million Btu (MMBtu) in July 2008, before trending down to seven-year low level of sub-$2 per MMBtu (we are referring to Henry Hub spot prices here) in September 2009. This, together with tighter access to credit, has prompted producers to scale back drilling operations over the past few quarters.

The supply picture is expected to reverse in the coming months as the lag effect of the sharp drop in domestic drilling activity takes hold. But we do not think this would be enough to offset the record high inventories (storage levels remaining 12% above their five-year average) and steep recession-related cuts in demand. This translates into limited upside for natural gas-weighted companies and related support plays.

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 China’s CNOOC Ltd. (CEO) and China Petroleum and Chemical Corporation, or Sinopec (SNP), both of which remain well-placed to benefit from the country’s growing appetite for energy.

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, Sinopec is the second largest crude oil and natural gas producer, and the largest refiner and marketer of refined petroleum products in China. Sinopec’s leverage to the lucrative Chinese market and the recent $7.5 billion Addax acquisition is expected to help sustain its growth momentum.

Within the oilfield services group, we prefer to own 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 recently posted better-than-expected third quarter results and raised its 2009 forecast, as a revival in energy prices led to improved drilling activities.

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 (NBR) and Patterson-UTI (PTEN), given the extent of excess capacity in the sector that is expected to weigh on dayrates and margins well into next year.

As expected, natural-gas woes in North America have pulled down the oilfield services companies’ third-quarter results. In particular, we remain wary of service providers like Smith International Inc. (SII), given its high North American exposure (from the W-H Energy acquisition) in the face of a collapse in the region’s drilling activities. We have Neutral recommendation on the company, whose third quarter results came in significantly below expectations.

Within the E&P group, we see little reason for investors to own shares of Stone Energy Corp. (SGY). We believe that Stone’s asset portfolio, centered on the Gulf Coast/Gulf of Mexico regions and lacking meaningful exposure to the emerging shale plays, is not suited for the current environment of low commodity prices and restricted access to capital.

We also maintain our cautious view on oil refiners, given the higher-than-average gasoline and distillate stocks — a combination that will continue to hurt their profitability going into 2010. Additionally, the sharply lower refinery utilization (at around 82% of capacity) provides enough evidence that refineries are cutting back on production because the economy is still struggling on the demand side.

Being the largest independent refiner, Valero Energy Corp. (VLO) remains particularly exposed to this unfavorable macro backdrop. We have an Underperform recommendation on the company.

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