(VLO) Oil and Natural Gas Stock Outlook – July 2011 – Industry Outlook

Crude Oil

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, which saw the commodity zoom past the $110 per barrel level earlier this year.

However, apprehensions about high U.S. crude stocks, the release of emergency oil supplies from government-held strategic reserves into the world market, and uncertainty over oil supply disruptions in the Middle East have been weighing on investor sentiment, weakening oil prices to less than $100 a barrel.

But far too many factors weigh on oil prices to definitively size up each one of them for their respective impact on prices. Some of those factors include OPEC decisions, geostrategic tensions the value of the U.S. dollar and seasonal variables, etc.

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 domestic 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 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 1980s 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. The 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 270,000 barrels per day, lower than in the earlier version, as the agency sees world economic growth lagging expectations.

Recently, the Organization of Petroleum Exporting Countries (OPEC) – the oil cartel that supplies around 40% of the world’s crude – also trimmed its 2011 world oil demand outlook, citing the unsteady global economy that has added risks to the forecast. OPEC predicts that global oil demand will increase by 1.36 million barrels per day annually, reaching 88.18 million barrels a day in 2011 from last year’s 86.82 million barrels a day. The organization’s current estimate for 2011 is lower by a marginal 20,000 barrels a day from its last report, issued in June 2011. In 2012, OPEC expects global oil demand to grow at a slightly lower 1.32 million barrels per day.

However, the third major energy consultative body, the Paris-based International Energy Agency (IEA), forecasted marginally stronger-than-previously-anticipated global oil demand in 2011. In its latest ‘Oil Market Report’, the IEA, an energy-monitoring body of 28 industrialized countries, said it expects world oil demand to grow by 1.2 million barrels per day in 2011, reflecting an upward revision of 200,000 barrels a day over the previous assessment, mainly driven by the non-OECD (Organization for Economic Cooperation and Development) economies. The agency – in its first 2012 forecast in a monthly report – added that global oil demand next year is expected to rise by 1.5 million barrels per day year-over-year to a hefty 91.0 million barrels per day.

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.

Natural Gas

A supply glut pressured natural gas futures for much of 2010, as production from dense rock formations (shale) 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%.

However, stocks of the commodity slid approximately 2.261 trillion cubic feet (Tcf) during the five-month period (November 5, 2010 to April 1, 2011) on the back of a colder-than-normal end to this past winter, production freeze-offs in January/February and the steadily declining rig count. These factors cut into the U.S. supply overhang, thereby creating a deficit in natural gas inventories after erasing the hefty surplus over last year’s inventory level and the five-year average level.

But with the end of the winter’s peak in heating demand, natural gas prices continue to be under pressure against the backdrop of sustained strong production. Producers are now hoping that the gap between supply and demand will further narrow in the coming months as they bet on a hotter-than-expected summer and an active hurricane season.

Looking forward, the EIA expects average total production to rise by 5.8% in 2011 and by 0.9% in 2012, while total natural gas consumption is anticipated to grow by 2.0% this year and decline slightly (by 0.2%) during the next year.

We believe these supply/demand dynamics – the projected lower production growth and almost flat consumption – 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.

OPPORTUNITIES

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 Royal Dutch Shell plc (RDSA).

The current oil price environment should also benefit producers, particularly those international players having attractive growth opportunities in their home markets. One such standout name is China’s CNOOC Ltd. (CEO), which remains 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.

Within the oilfield services group, we like Core Laboratories N.V. (CLB). We are a fan of Core Labs’ leadership position in the reservoir optimization niche, along with its global footprint and deep portfolio of proprietary products and services. Furthermore, the company’s low asset intensive operations and limited capex needs allow it to generate substantial free cash flows.

Halliburton Co. (HAL), the world’s second-largest oil services firm after Schlumberger Ltd. (SLB), is also a top pick. We like Halliburton’s leading position in the global oilfield services market, along with its broad and technologically-complex product and service offerings, and its robust financial profile. Since the last few quarters, the company has been benefiting from increased activity in the unconventional oil and gas shale plays in North America, which have more than made up for the drop in deepwater Gulf of Mexico activity.

We are also positive on Canada’s biggest energy firm and the largest oil sands outfit Suncor Energy Inc. (SU), reflecting the company’s impressive portfolio of growth opportunities, unique asset base and high return potential in the long run. Suncor has a significant oil sands and conventional production platform, huge long-lived oil-sands reserves and a robust downstream portfolio. The company’s asset base includes substantial conventional reserves and production at offshore Eastern Canada and in the North Sea, which generate strong margins and should provide free cash flow to fund future oil sands expansion.

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 last year’s 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 worth a look. 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. An 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), Tesoro Corp. (TSO), and Western Refining Inc. (WNR).

WEAKNESSES

We are bearish on South African petrochemicals group Sasol Ltd. (SSL), concerned by the group’s unfavorable operating environment – characterized by a strong domestic currency and weaker refining margins – and its expensive growth strategy, which will stretch Sasol’s medium-term returns significantly.

Engineering and construction firm McDermott International (MDR) is another company we would like to avoid for the time being, mainly due to the tentative commodity price scenario and the company’s clouded post-split outlook. Near-term bookings remain lumpy at McDermott, as the current uncertain environment has adversely affected the economics of building new oil and gas infrastructure.

We are also skeptical on integrated energy firm Marathon Oil Corporation (MRO), following its recent split into two separate entities, by separating its downstream business into an independent company. We believe that transfer of the downstream assets (post-split) will leave Marathon with a less diversified business. As a result, the business risk profile of the reorganized Marathon will be weaker than that of the pre-spin-off company. The recent decision by ConocoPhillips (COP) to follow Marathon’s lead has effectively raised question marks about the entire business model. But it may be a too soon to write off the integrated oil company model.

Lastly, we expect shares of independent oil and gas company Forest Oil Corporation (FST) to be under pressure in the near future. Though the Granite Wash play continues to perform well with an increasing acreage position, we are concerned with the company’s debt-heavy balance sheet, as well as its weak reserves growth profile. Additionally, with natural gas accounting for approximately 77% of total production (as of March 31, 2011), Forest Oil is exposed to the tentative outlook of the North American natural gas market.

CNOOC LTD ADR (CEO): Free Stock Analysis Report

CORE LABS NV (CLB): Free Stock Analysis Report

CABOT OIL & GAS (COG): Free Stock Analysis Report

FOREST OIL CORP (FST): Free Stock Analysis Report

HALLIBURTON CO (HAL): Free Stock Analysis Report

MCDERMOTT INTL (MDR): Free Stock Analysis Report

MARATHON OIL CP (MRO): Free Stock Analysis Report

PATTERSON-UTI (PTEN): Free Stock Analysis Report

ROYAL DTCH SH-A (RDSA): Free Stock Analysis Report

SCHLUMBERGER LT (SLB): Free Stock Analysis Report

SASOL LTD -ADR (SSL): Free Stock Analysis Report

SUNCOR ENERGY (SU): Free Stock Analysis Report

TESORO CORP (TSO): Free Stock Analysis Report

VALERO ENERGY (VLO): Free Stock Analysis Report

WESTERN REFING (WNR): Free Stock Analysis Report

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