Mutual Fund Commentary
A DRAG ON OIL & GAS PRODUCERS
The shale revolution started with natural gas, but subsequently expanded to crude oil. In our view, shale development was a key catalyst in crude oil prices becoming unglued in late 2014, in much the same way that natural gas prices became unglued a few years earlier. Somewhere in the nexus of crude oil and natural gas development, however, are natural gas liquids (NGLs): liquid hydrocarbon molecules that are trapped within natural gas. NGLs sometimes get lumped in with their liquids cousin, crude oil, but doing so is a mistake in our opinion - because a barrel of crude oil is worth considerably more than a barrel of NGLs. So S&P Capital IQ thinks understanding a given producer's overall liquids production profile is not sufficient: it's important to also know whether those liquids barrels are of the crude oil variety or the NGL variety. And at that more granular level, we see some striking differences across individual companies.
Peeling back the NGL onion a little further, NGLs in turn are a loose collection of five different carbon/hydrogen combinations. Skipping the actual chemistry, these are better known as ethane, propane, normal butane, isobutane, and natural gasoline. These five combinations exist in varying degrees depending on geology, but generally speaking, ethane and propane are the most naturally occurring NGLs, comprising perhaps 70% of a barrel of NGLs. Looking at these key NGLs, what we find is a blossoming of supply that has outstripped demand, bloated inventories, causing pricing to crash.
Bentek Energy, a unit of Platts and a sister company to S&P Capital IQ, projected the total U.S. NGL supply to rise to 4.8 MMb/d by 2020, versus 2.5 MMb/d in 2012 - an implied CAGR of about 8.5%. Already, in less than three years, NGL supply has shot past the 3.5 MMB/d mark. In contrast, Bentek sees NGL demand rising to 5.2 MMB/d by 2020, a CAGR of just 6.7%. In addition, much of the demand growth implied in that forecast is to be derived from exports to foreign markets - which in turn is dependent on LPG (liquified petroleum gas) vessels meeting that demand. Yet at present, LPG export capacity is just 0.73 MMb/d, and would have to grow to more than 1.7 MMb/d by 2020, which we think is aggressive.
S&P Capital IQ believes inventories of these key NGLs remains high. Total stocks of propane and its related product, propylene, are 64% above the five-year average. Propane prices at key hub Mont Belvieu, TX are under $0.50 per gallon, less than half of what they were a year ago. As a percentage of West Texas Intermediate crude oil prices, propane used to trade for somewhere between 40 and 60 cents on the dollar, and today are well under 40 cents. Similarly, ethane/ethylene stocks are 11% above the five-year average. Ethane prices are so cheap, that the ethane 'frac spread' - the value of the ethane less the cost of the natural gas used to obtain it - is negative. Companies would rather reject the ethane back into the dry gas supply, but there are pipe specification limits on how much this can be done. As a fraction of WTI pricing, ethane fares even worse than propane - it sells for less than 20 cents on the dollar. Overall, the NGL barrel is trading below 40 cents on the dollar at Mont Belvieu. Only natural gasoline is showing any strength of late, and even then has begun to pull back on price.
Given the ongoing growth in supply, our view that prices will remain under pressure for all key hydrocarbons (crude oil, wet gas, and dry gas), and the expectation that exports will save the day, we are not optimistic on any kind of near-term recovery in NGL pricing. The next question becomes: how influential is NGL pricing on E&P production?
Looking at Capital IQ consensus estimates for 2016 in our E&P coverage, ,the median E&P on a barrel of oil equivalent basis looks to derive about 39% of its total production from crude oil, 13% from NGLs, and 48% from natural gas. Put another way, if one just looks at the liquids portion of production, the median E&P should produce one barrel of NGLs for every three barrels of crude oil. However, not all E&Ps are built this way: some have considerably greater exposure to NGLs relative to their crude oil exposure, which, excluding the impact of hedges, should mean correspondingly weaker realized pricing from their liquids exposure.
Perhaps the weakness in NGL exposure could be mitigated if WTI crude oil prices climbed higher (i.e., 40 cents on the dollar of a growing pie). However, based on current Bentek forecasts, that does not look likely. Bentek sees WTI crude oil averaging $53.50 per barrel in '15, $55.00 per barrel in '16 - well below the current $61 per barrel.
We look at three large-cap E&Ps with average or higher liquids exposure, along with high NGL exposure.
First, Cimarex Energy (XEC 118 **), with 21% of its overall production derived from NGLs. For every five barrels of crude oil, XEC is delivering two barrels of NGLs - one of the highest such exposures in our coverage universe. XEC does boast some strong acreage positions in the Permian Shale, which we think is a factor in trading well above historical averages on a forward cash flow basis, but we think that premium is too aggressive. Our 12-month target price of $110 on XEC implies a forward cash flow multiple of 8X, which we think reflects a sufficient premium to peers, but is below current premium levels.
Second, Devon Energy (DVN 62 **) with 20% of its projected 2016 production derived from NGLs. We apply a 5X multiple to projected 2016 operating cash flows to generate a 12-month target price of $56 - slightly above DVN's historical forward average.
Third, Pioneer Natural Resources (PXD 142 **), which, while owning strong acreage in the Eagle Ford and Permian Basins, has the distinction of a free cash flow deficit that looks to be wider than that of any other large-cap E&P name in our coverage universe. Based on Capital IQ consensus estimates, we think PXD generates operating cash flows amounting to 68% of projected 2016 capital spending, versus a peer average of 86%. Our 12-month target price of $120 implies a 9.5X multiple of projected 2016 cash flows, a roughly 20% premium to PXD's historical forward average, but still below current elevated levels.
All three of these stocks are priced at least 20% above their 5-year historical forward averages on either forward EBITDA or forward cash flows, and are at least flat or better than peers for stock performance year to date. XEC is up 11%, DVN is up 1%, and PXD is down 5%, versus a peer average that is down5%. We think current valuation premiums suggest that the market is embedding a return to rosier pricing, and we are less optimistic on this front. With stocks seemingly factoring in this kind of upward pricing traction, we advise investors to be cautious with these names.
For those investors looking for a more diversified angle on these names, we note that three ETFs contain two of them amongst their top 10 holdings (although none contain all three). The iShares US Oil & Gas Exploration & Production ETF (IEO 73 Underweight) contains both PXD and DVN, as does the Market Vectors Unconventional Oil & Gas ETF (FRAK 22 Underweight). Meanwhile, the PowerShares DWA Energy Momentum Portfolio ETF (PXI 47 Underweight) has both PXD and XEC in its top 10 holdings.