Oilfield services stocks appear to be the most undervalued.
The S&P 500 Energy index has already lost more than 15% so far in 2020, following the coronavirus outbreak and the likely knock-on effect on crude demand growth. The market has overreacted, in our view, making energy stocks look cheap at current levels.
In December, crude demand growth for 2020 was estimated at 1.25 million barrels per day (averaging forecasts from the Energy Information Administration, International Energy Agency, and OPEC). That would have been a modest rebound from the prior year, but lower than the recent trend; demand growth averaged 1.6 mmb/d in 2016-18. Now, the same forecasters are calling for just 960 thousand b/d growth in 2020, implying a 300 mb/d decrease due to the virus. The full impact could be more severe. By comparing the recent outbreak with the 2003 SARS outbreak, Capital Economics has estimated a 400 mb/d impact and notes that this is probably underestimating because China’s economy is more globally integrated today. In addition, while the coronavirus appears to have a lower mortality rate than SARS, there have been far more infections and there is still the possibility of a full-blown pandemic. As such, it appears the likely effect on crude demand will be more substantial than what most forecasters anticipate.
However, there may be too much optimism on the supply side as well. Before the outbreak of the virus, OPEC and its partners had already pledged to reduce output by 500 mb/d in the first quarter relative to the group’s previous ceiling. While the latest figures do show a decrease of that magnitude in January, most of this came from Libya, where ongoing civil unrest is affecting production and transport. It is therefore much less likely that volumes will jump back up when the additional cuts are scheduled to expire March 31. And it isn’t clear the group will let the cuts expire at all–the coronavirus could justify an extension, perhaps through the end of the year.
In addition, we think the market is underestimating the impact of last year’s slowdown in the U.S. shale patch. The horizontal rig count has fallen 22% in the last 12 months, reflecting the shifting focus of producers from growth to returns. The IEA still expects growth of 1.1 mmb/d in the United States this year, over 200 mmb/d more than our forecast. The combined impact of prolonged OPEC cuts and a greater-than-expected U.S. slowdown is probably enough to offset the loss of demand due to the virus.
Oilfield services stocks appear to be the most undervalued among the energy subsectors, with an average discount of 40% to our fair value estimates. Integrated oils and refining stocks are also priced attractively, with an average discount of about 30%. Midstream stocks have less commodity sensitivity and are therefore only 20% undervalued based on our estimates. Upstream stocks are somewhere in between, with an average discount of 25%.
We think oilfield services stocks are so mispriced because the market is failing to appreciate the required increase in oil and gas capital expenditures in the next several years, particularly in international markets. We forecast 16% cumulative growth in capital expenditures through 2023, whereas we peg the market-implied view at a meager 6%. We think the market is mistaken in assuming that international markets can copy U.S. shale’s remarkable cost-cutting. Instead, we forecast a strong 23% international expenditure recovery, driving the bulk of our forecast capital expenditure increase through 2023.
Integrated stocks are cheap for a variety of reasons. In the short term, the group has suffered from macroeconomic headwinds across all of its major segments–upstream, downstream, and chemicals–as softness in global economic conditions and oversupply have weighed on margins. It’s rare for the group to experience weakness in each segment simultaneously. We also think the market continues to overly discount the cost improvements and reduction in break-even levels the group has made during the last five years. The long-term sustainability of oil and gas demand is also likely playing a role, and as the largest companies in the sector, integrateds are probably taking the brunt of this concern. Taken together, all these issues cause investors to call into question companies’ ability to increase dividends and repurchase shares. We think these concerns are overblown, however, leaving the stocks trading at steep discounts.
Refiners are suffering from weak gasoline margins and narrow crude spreads that are weighing on profits. Given that the refined product trade is global, any demand weakness in Asia related to the virus would eventually flow back to U.S. refiners, which rely on export markets. As such, concern about further weakening demand, if the virus spreads, is sending shares lower. The lack of a material boost in margins from the enactment of IMO 2020 emission standards has also left the market disappointed. Both issues are short term, however, and we continue to like the long-term outlook for U.S. refiners that hold a cost advantage relative to global peers, which should keep them running at high levels of utilization even if demand wanes.
Originally Posted on February 27, 2020 – Market Overstates Coronavirus Impact on Energy Stocks
Mentioned: TechnipFMC PLC (FTI), US Silica Holdings Inc (SLCA), Hi-Crush Inc (HCR), Frank’s International NV (FI), Smart Sand Inc (SND), Baker Hughes Co (BKR), Covia Holdings Corp (CVIA), Weatherford International PLC (WFTLF), National Oilwell Varco Inc (NOV), Halliburton Co (HAL)
Dave Meats, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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