Demand for oil will continue to rise as developing economies in Asia and elsewhere fuel their rapid growth. Here’s how to play a bullish outlook on oil.
by Lou Gagliardi and Kevin Kaiser, Hedgeye
As we move into 2011, we remain bullish on crude oil fundamentals for the long term. Increases in merger and
acquisition activity and in capital spending by the oil and gas industry reinforce our view. And countries in the developing world, particularly from Asia, will continue to demand more barrels to fuel their economic growth.
Energy companies are looking over the horizon to bring projects forward to capture demand as it strengthens. Support for crude prices will be driven primarily by supply constraints, particularly production declines in major basins worldwide, including: Mexico, Norway, North Sea, Alaska North Slope, Venezuela, conventional plays in Canada and the U.S., and mature fields in Western Siberia. Other supply constraints are limited access by Western Majors to major producing basins of the world, rising costs, geopolitical instability, and energy insecurity by energy short nations.
On the demand side, accelerating GDP in emerging market nations and rising inflation fears will funnel greater investment capital to target inflation hedges in the form of commodities, particularly oil. We remain bearish on natural gas due to improved technology and oversupplied storage weighing on price. We see no reduction in production levels until perhaps the second half of 2011, with increasing risk to the sector of consolidation and bankruptcies.
With our bullish bias to crude oil price, we look for producers that are highly levered to crude oil and have positive production growth in their upstream profiles for 2011. These are the companies that are positioned to benefit from higher crude prices in 2011 and accelerating demand going forward.
Here we highlight our top 10 picks.
At the top of our list is China’s national oil producer, CNOOC. It is 71% state-owned and aptly named CEO, as in CEO of the energy world, and is up more than 51% year-to-date. Government owned, it has a lower cost of capital that has enabled it to make several significant acquisitions in 2010, and we don’t think they are through yet. CEO currently has an 82% oil weighting in its production profile, and with 2010 acquisitions the company could easily grow production by roughly 10%-12% in 2011.
Coupled with crude prices on the upswing in 2011, and using a conservative oil price of $85 per barrel for 2011, CEO could grow 2011 earnings roughly 40% from 2010 to $22.10 per ADR, which would easily top consensus estimates. Using a crude price of $89 in 2011 will add about another $2 in earnings and roughly $1 billion in cash flow. Net cash flow (NCF) after capital spending and dividends could grow to roughly $3 billion, or $7.40/ADR. The company also boasts a strong balance sheet with debt to capital at about 13%, and net of cash at negative 2%.
MEG Energy is a bitumen producer based in Calgary, Alberta with shares traded on the Toronto Stock Exchange. We expect MEG’s 2011 earnings to benefit from a full year in operation, a 3% increase in oil sands production lower operating costs per barrel, and expanding margins. With its strong balance sheet, a strategic partner in China’s CNOOC owning 15%, debt-to-capital at 21% and net of cash at negative ~13%, we believe MEG is being underpriced by the market by roughly 30%.
The company is sitting on roughly C$1.4 billion in cash — more than enough to meet its expected net cash flow deficit after capital spending of roughly ~C$600 million for 2011. It is in the growth mode, ramping up production for its next phase of expansion at Christina Lake, with expected start-up in 2013. Based on $85 oil in 2011, MEG’s 2011 earnings should top consensus, reaching ~C$0.92 per share, up more than 150% increase from 2010. Should crude oil average $89 in 2011, MEG’s earnings could go about 16% higher to ~C$1.06.
Predominately an oil sands mining operation, Suncor — also based in Canada — is 87% weighted to company-wide oil production and 67% to oil sands production in its upstream portfolio. SU’s 2011 earnings will be driven by higher crude prices, 14% higher oil sands production, and a 12% increase in overall upstream production. Higher production will drive down operating cost per barrel and expand margins. Its balance sheet is strong with debt-to-capital at 25% and net of cash at 24%.
Underpriced by the market by about 30%, SU is living within its means, with expected net cash flow at ~C$1.1 billion for 2011 at $85 per barrel oil. In addition, SU expects to garner about C$3.5-$4B in cash proceeds from asset disposals begun in 2010. At $85 oil, SU’s 2011 earnings should reach ~C$2.40/share, or roughly a 58% increase from 2010. If crude oil averages $89 in 2011, SU’s earnings could increase about 9% further to C$2.63/share. Higher production driven by greater capacity and a return to full upgrader utilization in 2011 should drive operating costs lower by about 13%.
Among the majors, CVX is the most levered to rising crude prices in 2011. CVX has the highest oil production weighting in its portfolio at 70%, and coupled with the best oil production growth among its peers, its upstream earnings growth stands to benefit the most in 2011. Year-to-date in 2010, oil production by the majors declined 1% worldwide and decreased 3% in the U.S. Only CVX and Royal Dutch Shell (RDSA) have registered positive 2% oil production growth worldwide, and CVX recorded a 4% increase in the U.S., best among the majors.
Although we project modest growth going forward into 2011, CVX should post positive growth of at least 1% relative to its peers. At $85 per barrel crude oil in 2011, we expect CVX to easily beat consensus with a 15% increase in earnings per share from 2010 to $10.31/share. At $89 oil, earnings would jump nearly 22% from prior year to nearly $11.00/share. Chevron’s balance sheet remains strong, with low debt leverage, debt to capital at 9.5%, and net of cash at negative ~-4%.
A high oil weighting (74%), international assets, and Bakken oil shale exposure are main drivers behind Hess’s earnings growth going into 2011. Particularly, North Dakota’s Bakken oil field in the Williston basin, where HES is the third largest oil producer and the largest gas producer, will drive its U.S. production growth. Current production from Bakken is 18,000 boe/d, with a 2010 exit rate targeted at 20,000 boe/d, and targeting 80,000 boe/d by 2015 – this would nearly double U.S. overall production.
Recent acquisitions in 2010 of American Oil & Gas (85,000 net acres) and TRZ’s acreage (167,000 net acres) in the Bakken could push HES’ production over 30,000 boe/d in 2011. At $85 crude oil in 2011, we expect HES to beat consensus with a 15% EPS increase from 2010 to $6.24/share. At $89 oil, earnings would jump nearly 50% from prior year to nearly $7.04/share, adding another $130 million in net cashflow. Hess has modest debt-to-capital at 26%, and net of cash at 17%.
HOLLY CORP. (HOC)
A niche refiner located primarily in the Southwest U.S., Holly has limited regional competition. HOC has a balanced distillation-to-upgrading ratio of nearly one-to-one — balanced upgrading allows it to optimize its operating leverage during periods of both high and low crude differentials. With a strong balance sheet and modest debt leverage – 34%, net of cash at 23%, and a high EBITDA-to-debt, or “interest coverage” ratio of 5.4, HOC is well positioned to weather challenging refining conditions in the long run.
HOC trades at a discount to its peer Frontier (FTO) and a premium to Valero (VLO) at nearly eight times 2010 estimated EBITDA. Driving this higher valuation is its unique market position, its high distillate yield that capitalizes on wider margins and growing diesel demand in the U.S., and its top net income and margin per barrel. Generating the best net income per barrel and income margin among its peers in 2010, we expect HOC to continue to outperform fellow domestic refiners in 2011.
Although labeled a National Oil Company (NOC), Lukoil is 100% publicly owned. Yet geopolitical risk, the Russian economy, and an onerous export tax duty have all weighed heavily on Lukoil’s share price in 2010, widening its market price discount to its discounted cash flow valuation further to 50%. Historically, NOCs trade at a steep discount to cash flow valuations and Lukoil’s historical discount has been in the 30% range.
We believe its market discount will narrow, reverting to the mean in 2011, driven by several catalysts. Lukoil’s high oil production weighting of 87% levers its share price to higher crude prices; its long-term reserves, its expanding production profile internationally, and its growing crude oil production profile of ~2% per year will contribute to significant earnings growth in 2011. Lukoil’s balance sheet is strong with a debt-to-capital ratio of ~16% and a net of cash ratio at ~12%, meaning it’s living within its capital spending. At $85 crude oil in 2011, we expect Lukoil to easily beat consensus with a ~25% EPS increase from 2010 to $14.75 per ADR. For 2011, net cash flow at $85 per barrel oil is targeted at $8.4 billion, or $10.12 per ADR. At $89 oil, earnings would jump 35% from prior year to nearly $16 per ADR, adding roughly another $1 billion in net cash flow.
NORTH AMERICAN ENERGY PARTNERS (NOA)
This Canadian oil sands resource “services” provider has been hit hard by the downturn in Oil Sands project expansion that began in 2009 and continued into 2010. NOA provides oil sands mining and site preparation, piling and pipeline installation services: as of the end of September, revenue from oil sands services generated 83% of net revenue, 84% of which is recurring revenue. Although its balance sheet remains under pressure at ~57% debt-to-capital and net of cash at ~50%, recent projected increases in capital spending by oil sands companies and the resumption of oil sands growth projects is good news for NOA, which will benefit from increased project spending.
Oil sands project growth will provide the catalyst to earnings growth into next year. For NOA’s fiscal year ending March 2011, earnings are expected to decline 21% to C$0.61/share, but earnings for fiscal year 2012 (beginning in April 2011) should bounce back by ~120% to $1.36/share, driven by higher oil sands spending. Net cash flow for both years should remain positive, with fiscal 2012 expected at $32 million or C$0.90/share.
CANADIAN OIL SANDS TRUST
The company is converting to a corporation from a trust organization at end of December 2010. The stock recently took a hit on news that COS will cut its dividend payout ratio in half upon conversion to a corporation in order to maintain cash flow within capital spending. COS is 100% levered to oil sands production, as the largest partner (36.74% interest) in the Canadian Syncrude Joint Venture.
We view COS a company with upside earnings potential in 2011 — potentially a 63% increase from 2010 to C$2.04/share at $85 oil, and net cash flow positive C$0.20/share after capital spending. At $89 per barrel oil, earnings could increase further to C$2.28/share, with net cash flow at C$0.45/share. We view shares as oversold, as the market overreacted to the dividend reduction news, presenting a buying opportunity. COS is undervalued by roughly 30% according to our discounted cash flow models. The company’s operating fundamentals remain strong, particularly with high oil price leverage. The balance sheet has a moderate debt-to-capital ratio at ~23%, net of cash at ~21%.
OIL SERVICES (OIH)
Increases in capital expenditures by the world’s major integrated oil companies, a boom in U.S. shale plays, and an aging fleet of rigs are all tailwinds for the oil services industry in 2011. Chevron recently announced that it will boost capital spending by 20% in 2011 and we anticipate that its counterparts will follow suit. Shell, TOTAL, ConocoPhillips, and ExxonMobil have seen production declines in recent years and need to increase spending in the upstream to fend off further drops.
In the U.S., the boom in horizontal drilling has completely changed the future of recovery techniques for gas and oil. Horizontal rigs are up 80% this year while vertical rigs have trended flat. Advantage = oil services. Horizontal drilling consumes more “pipe” and wears it down faster. The pipe life for vertical rigs is 4-5 years while it is 2-3 years for horizontal rigs. Not only that, but horizontal rigs demand more powerful bits and motors to handle the torque of “the turn.” Lastly, the global rig fleet is aging and needs upgrading. 75% of the world’s “jack-up rigs” are older than their 25 year recommended shelf-life.
With “easy oil” in decline, exploration and production will occur in increasingly difficult and unconventional land and waters for which new, technically advanced rigs will be required. We are bullish on the entire sector (which can be played via the ETF OIH), though our favorite name is National Oilwell Varco (NOV).