Key Takeaways:
· The dynamics of the crude oil and natural gas markets are inherently difficult to predict.
· However, we think informed upside, base, and downside cases as it relates to crude oil and natural gas prices are critical to the underlying forecasts of our valuation models (and the fair value estimate ranges of firms across our coverage universe).
· Crude Oil
o Our base-case forecast for the price of crude oil is roughly $90 per barrel by the end of 2018. Our upside case is approximately $120 per barrel, while our downside case is approximately $60 per barrel.
o We think an appropriate long-term base-case assumption for crude oil prices is $160 per barrel (Brent) by 2035. We believe, as a result of socio-economic reasons in OPEC nations, that crude oil will not be below $100 per barrel at the end of our long-term forecast horizon. We use the EIA’s ‘High Oil Price’ case of roughly $230 per barrel in 2035 as our upside range (though we admit speculative spikes could even make this forecast pessimistic).
o The magnitude of potential shale oil supply from Bakken, Eagle Ford and Niobrara in the US (and internationally—Argentina, Russia, and China) are big wild cards and pose the greatest risk to our base-case crude oil forecast.
· Natural Gas
o Our base case scenario for the Henry Hub spot price is roughly $5 by 2018, resulting in corresponding upside and downside scenarios of $7 and $3, respectively.
o We think further upside to total proved and unproved natural gas supply and ongoing technological advancements could keep a lid on material natural gas pricing expansion for some time to come. As such, our long-term forecasts for natural gas prices mirror those at the tail end of our 5-year horizon.
· Ideas
o Chevron (click ticker for report: ), a holding in the portfolio of our Dividend Growth Newsletter, is our favorite income idea in the space. The company boasts a 3.3% annual dividend yield and is the only large major with a net cash position on its balance sheet (it receives high marks on the Valuentum Dividend Cushion for this). The company’s returns on capital employed have been in the teens, and its reserve replacement ratios have been sufficient as of late. The high end of our fair value estimate range for the firm is over $150 per share.
o We like Kinder Morgan (click ticker for report: ) and Energy Transfer Partners (click ticker for report: ) as our favorite pipeline plays. Each boasts a hefty distribution, and we’re particularly fond of their positions in the Eagle Ford.
o We’re also fans of Phillips 66 (click ticker for report: ), which continues to boost its dividend, while pursuing a very lucrative advantaged-crude strategy, which we believe may last longer than consensus expectations.
· Takeout Candidates
o We point to Continental Resources (click ticker for report: ) and EOG Resources (click ticker for report: ) as our favorite M&A targets. Continental Resources is the largest leaseholder in the Bakken, while EOG Resources is the largest leaseholder in the Eagle Ford (EOG has a nice position in the Bakken as well). Anardarko (click ticker for report: ) also makes our short list of takeout candidates given its position in Eagle Ford and Niobrara. We could see the majors take a stab at accumulating properties in these areas in coming years.
· We’re watching proved reserves replacement ratios closely.
o ConocoPhillips (click ticker for report: ) revealed the best organic reserve replacement ratio out of the majors in 2012. BP (click ticker for report: ) and Royal Dutch Shell (click ticker for report: ) failed to replenish their respective reserves during the year.
Tickers mentioned: XOM, CLR, EOG, HES, MRO, OAS, WLL, BHP, CHK, APA, APC, COG, PXD, EPD, KMP, PAA, ETP, NBL, BBG, KWK, VLO, PSX, CVX, COP, BP, RDS.B
Key Sources
To access the US Energy Information’s 2013 Annual Energy Outlook, please click here.
To access the OPEC Annual Statistical Bulletin, please click here.
To access the OPEC World Oil Outlook, please click here.
To access Exxon’s 2013 Outlook for Energy: A View to 2040, please click here.
Why Forecast Crude Oil and Natural Gas Prices?
As subscribers of Valuentum know, every company’s fair value estimate is corroborated by a comprehensive and robust three-stage discounted cash-flow valuation model. Within these cash flow models are hundreds of assumptions, ranging from future forecasts of revenue to a firm’s cost structure to fading returns on invested capital to a company’s cost of capital over time (competition will eat away at returns over time causing economic profit creation to cease).
The significant implications of the price of crude oil and natural gas on our fair value estimates cannot be underestimated – and not just within the energy sector. The transportation industry (from airlines to trucking firms) includes energy as its single-largest input expense. The profitability of companies that make chemicals, rubber and plastics are all influenced by petrochemical feedstock prices. Even the best-selling cars at some of the automakers can be influenced by the price of gasoline at the pump. The list goes on and on.
Valuentum uses its internal crude oil and natural gas price deck to inform the future revenue and input cost forecasts for relevant companies across its entire coverage universe. Though the dynamics of the crude oil and natural gas markets are inherently difficult to predict, we think informed upside, base, and downside cases as it relates to crude oil and natural gas prices are critical to the underlying forecasts of our valuation models (and the fair value estimate ranges of firms in our coverage universe). Such a range of probable fair value outcomes is consistent with our use of a margin of safety within the Valuentum methodology.
Crude Oil
We’re Expecting Lower Crude Oil Prices in the Near Team…
Our base case near-term (5-year) crude oil price assumptions are derived from the CME Brent Crude Oil futures curve. Though there are myriad factors that can drive wild fluctuations in the price of crude oil relative to the futures curve (not the least of which is the relationship between non-OPEC production and demand growth), the futures curve—in the most simplistic sense—reflects the average view among all market participants, which in many cases, is the best forecast.
At times, our near-term base-case crude oil price assumption will vary from the futures curve if, for example, our views regarding current geo-political (socio-economic) events, global gross domestic product growth, and supply-demand assumptions differ greatly from this ‘embedded consensus’ pricing assumption. However, the goal of this simplistic method is to set the baseline for the revenue-generating capacity of firms we cover in the energy sector and to provide the foundation for cost-structure changes of firms who rely heavily on crude oil and its derivatives as inputs.
To arrive at our near-term (5-year) upside and downside cases, respectively, we apply a standard $30 premium to the futures curve (base case) and a standard $30 discount to the futures curve (base case), both in year 5. The size of this particular margin of safety band (in units as opposed to percentage) is substantiated via the historical annual standard deviation of crude oil prices (Europe Brent Spot Price FOB), unadjusted for inflation, from May 1987 through the present date (raw data), which approximates such a figure ($31).
Our base-case forecast for the price of crude oil is roughly $90 per barrel by the end of 2018. Our upside case is approximately $120 per barrel, while our downside case is approximately $60 per barrel. The EIA projects the Brent crude oil spot price will fall to annual averages of $106 per barrel and $101 per barrel in 2013 and 2014, respectively, relatively consistent with Valuentum’s forecasts. OPEC is targeting a nominal price of $100 per barrel (OPEC Reference Basket) over the medium term.
We estimate that production costs of oil shale, which is advancing aggressively in the US, are between $60 to $120 per barrel, further substantiating this pricing range. Heavy oil bitumen (Canadian tar sands) will likely require $75 per barrel to be economical (also within the range), and all of the major independent oil companies currently boast significant tar sands reserves. We don’t expect ethanol and biodiesel to be significant sources of supply in the near future, given estimated costs for incremental supply that could top $130-$150. However, these estimates may come down in coming years as technology advances.
5-Year Range of Probable Outcomes for Crude Oil Prices (Europe Brent) – $/barrel
Source: EIA, Valuentum
…But Significantly Higher Crude Oil Prices Over the Long Haul
The US EIA uses the following key factors in determining the long-term supply, demand, and prices for petroleum and other liquids: the economics of non-OPEC petroleum liquids supply; OPEC investment and production decisions; the economics of other liquids supply; and world demand for petroleum and other liquids.
Let’s focus on the two most important drivers: supply and demand, the latter we’ll tackle first.
Long-term Outlook for Energy Demand
Though a wide range of outcomes should be applied to any long-term growth rate, firms such as Exxon Mobil (click ticker for report: Categories Member Articles