Shifting commodity prices are a given in the oil and gas industry, but sometimes the industry landscape changes in unexpected ways. In this interview with The Energy Report, Oppenheimer & Co. Managing Director and Senior Energy Analyst Fadel Gheit discusses the effect of Middle Eastern geopolitical issues on oil production, dissects the changing oil and gas production situation in the U.S. and explains how the shift in natural gas prices has turned the refinery business from the industry's perennial ugly duckling into a beautiful swan.
The Energy Report: During your last interview in March, you said that oil prices were inflated by about 30% based on replacement costs of about $70/barrel ($70/bbl). Do you still believe that or are prices more realistic today?
Fadel Gheit: Nothing really changed over the course of the year. Oil prices are still inflated. I still stand by my estimate that oil should be trading between $70 and $80/bbl, not $90 or $100/bbl.
TER: What are your top picks among the large-cap exploration and production (E&P) companies in the oil and gas space?
FG: There are three or four categories of companies. The large, integrated oil companies are Chevron Corp. (CVX:NYSE), Exxon Mobil Corp. (XOM:NYSE), Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE), Total S.A. (TOT:NYSE) and the like. This is a shrinking universe because most of these companies are breaking up. ConocoPhillips (COP:NYSE) used to be a major integrated company and it split into two separate companies. But of all the major integrated companies, Chevron has been the best-performing stock. It's highly leveraged to oil prices. It has a strong balance sheet and has really outperformed its peers and the S&P 500 in the last 10 years, so Chevron would be our top pick among the large-cap companies.
The large independent E&P companies are Anadarko Petroleum Corp. (APC:NYSE), Apache Corp. (APA:NYSE), ConocoPhillips and Occidental Petroleum Corp. (OXY:NYSE), and of all these companies, we like Occidental a lot because of its restructuring potential.
We like to pick stocks for investors, not make bets on oil and gas prices, because I've been in this business 30 years and I believe no one can accurately forecast oil and gas prices. We're trying to pick stocks that have a catalyst, or for which we expect a catalyst, that will increase valuations. Occidental is a good example. It had massive changes on the board; the chairman was not reelected and the lead member did not stand for reelection. Now the CEO is trying to break up the company and create much higher value for shareholders.
TER: You have suggested that Apache exit Egypt because of growing instability. What should the company do instead with the funds?
FG: Egypt is a problem that Apache or any other company cannot solve. The International Monetary Fund is trying to help Egypt, and Egypt's problems are daunting. The political, economic and civil situation in Egypt is likely to deteriorate even further. The main problem in Egypt probably is economic. It is a poor country with high unemployment, and it has lost the biggest revenue generator—the tourism industry.
Apache has the highest earnings exposure to Egypt; a big percentage of its profit is generated from the country. Although its operations have not been interrupted and Apache is getting paid its share of profit regularly with no delays, the market has concluded that Egypt is a big risk for Apache and therefore it is better for Apache to leave Egypt.
Apache would be better off selling its Egyptian assets to another company that has the appetite for this political risk and using the proceeds to buy back its stock. That will do two things: remove the risk, which means the shares will receive higher multiples of earnings and cash flow, and shrink the number of shares outstanding, thus improving earnings and cash flow per share and ultimately boosting the valuation. It's a win-win situation for Apache and for its shareholders.
TER: What other large caps and majors are in areas they should exit?
FG: No one wants to be in Libya because of the security situation. I have a dim view of the Middle East in general. The situation in Syria could drag the world into war, and that's the last thing we need. The troubles have spilled over into Lebanon and Iraq. Now Turkey, Russia and Iran are getting involved. This is really a very messy situation, which is going to get worse. Investing in North America is preferable because it's safer.
That's good for U.S. oil production. The U.S. is importing less and is producing more, keeping capital at home. Unfortunately, because of what is happening in the Middle East and uncertainty about supply and the expectation that we have, disruption could send oil prices back to $150/bbl, which we had five years ago.
TER: Your latest research on Hess Corp. (HES:NYSE), which is also a global producer and refiner, expresses concern that a threatened proxy fight is contrary to investors' best interests, but your rating for the company is Outperform. Why are you feeling ambiguous about Hess?
FG: Hess has lagged its peers in the market for many years because of bad decisions. That prompted activist hedge fund Elliott Group to take a large stake in Hess and to present investors with an alternative strategy to create shareholder value. It estimated that the stock should be worth no less than $97/share and as high as $123/share. The stock at the time was trading at $50/share, so the huge upside potential attracted a lot of attention and resulted in a proxy fight.
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"For American industries and the American consumer, lower natural gas prices will open up a second industrial renaissance."
The Elliott Group won the proxy fight 60% to 40%, and it had nominated five board members; Hess had nominated five new board members. The Elliott Group won, but settled for three board seats. Since then—that was a few weeks ago—a news blackout remains and the stock is going sideways because of the uncertainty. Under pressure from Elliott, Hess accelerated the restructuring plan. It is planning to sell $7.5 billion ($7.5B) of assets, mostly exiting the downstream operation, which is refining, marketing and transportation, and become a pure oil-and-gas producer with a big position in the Bakken in North Dakota. Of the proceeds from restructuring, $4B would be used to buy back stock, which is 15% or more of the shares outstanding, $2B to pay down debt and $1.5B to beef up liquidity on the balance sheet.
So far, the restructuring plan is more than 50% complete, and it is expected to be completed by the end of this year. The cash received exceeded the original estimate. We do not know whether the Elliott Group will be satisfied with that. I contacted Hess and urged the company to come up with a unified statement from the board, including those members representing Elliott, outlining the new strategy of the company. Until then, I think investors will take a wait-and-see attitude.
TER: Has this outcome affected your Outperform rating for the company?
FG: No. We had an Outperform on Hess for more than two years. At the end of the day, stocks are cheap for a reason. If this reason is removed, or at least dealt with, stocks usually seek their equilibrium and relative valuation. In the case of Hess, the company needed a catalyst and the catalyst came from Elliott. Shareholders are thankful for that, but it is only phase one of what I consider a multiphase strategy. The stock is up almost 30% since Elliott got involved, but that's a far cry from the bottom of the range of $97–123/share. I still believe that Hess has a lot of upside. We have a price target of $85/share, which is conservative, given the low valuation of the stock.
TER: Why do you think it is time for an American CEO at Royal Dutch Shell?
FG: Shell has tried the British side of the family and the Dutch side of the family. The retiring CEO is Swiss. Shell has $28B of investment in North America, and the most profitable growth for Shell and for the industry is deepwater Gulf of Mexico, so I think it's time for an American CEO to run Shell.
TER: Natural gas has now gone over $4 per thousand cubic feet ($4/Mcf). That's a price that you and many others have cited as a threshold for increased capital spending by producers. What is the Goldilocks price bracket for natural gas?
FG: Is the glass half empty or half full? We still have $90+/bbl oil or $100/bbl, if you look at the benchmark, and we have $4/Mcf gas. Natural gas prices in North America are still severely depressed. Unfortunately, they will remain depressed relative to crude oil and to gas elsewhere around the world. The reason, which is good news, is that the U.S. discovered a lot more gas than thought possible. Technology continues to uncover more and more of this gas.
Now the question is what do we do with this gas? I am not in favor of exporting LNG, although it might be necessary and it will probably bring some benefit to the market. But for American industries and the American consumer, lower natural gas prices will open up a second industrial renaissance. Any heavy industry that is a large consumer of energy would use natural gas—petrochemical facilities, manufacturing facilities, etc. It will give the consumer a break because it impacts the price of electricity and heat.
A lot of good things could happen, but the key here is whether the U.S. can harness natural gas as transportation fuel. This would reduce reliance on imported oil. It's much cleaner and cheaper than oil. Also, moving into transportation through the gas-to-liquid technology would create a lot of jobs in this country—millions of jobs and very high-paying jobs. It would give U.S. industries a tremendous competitive advantage because they would be using a cheaper source of energy than Europe, Japan or elsewhere.
"If we have a very big international crisis, oil prices are the barometer of how hot the situation is."
For domestic producers, $4/Mcf gas is better than gas at $3/Mcf. The industry continues to cut costs and improve operating efficiency to make money assuming that $4/Mcf or even $5/Mcf gas would be an average price that investors would be happy with. I don't think we are going to see any time soon the prices of natural gas in the double digits that we had five or six years ago. I also do not believe that gas prices can go back to where they were in April of last year, which was about $2/Mcf. Somewhere between $4–6/Mcf natural gas would be a good equilibrium. It will encourage spending by the industry and would generate a good return, but it's not going to be inflationary.
The U.S. needs a national energy policy. It needs direction. Instead of chasing renewable energy, ethanol, solar energy and whatever else—I'm not saying that they are bad or should not be addressed, but a U.S. energy policy needs to be more practical, to get people back to work and to reduce the budget deficit. If the U.S. can create incentives to open the door for investment in natural gas, natural gas pipelines and natural gas-driven industries, I think it would be very positive.
TER: How are the companies you cover responding to this price signal? What changes will it bring in exploration and production?
FG: They are doing a lot better than they were last year. Last year gas prices averaged close to $3/Mcf; now gas prices are above $4/Mcf, a significant percentage increase. The companies that lived through $2/Mcf gas are obviously a lot better off today. More important, it became a necessity for the companies to cut costs. The industry is a lot more efficient today than it was a year ago and a lot more than it was five years ago as technology continues to improve.
The industry currently favors oil or liquids. We are not going to see an appreciable change in investment that will be linked to crude oil prices because the valuation gap is so wide—the $4/Mcf gas is the equivalent of $24/bbl oil. When oil prices are $90–100/bbl, no one would allocate more capital to pure natural gas plays if the same capital could be deployed to drill for oil or natural gas liquids, which are discounted to crude oil but significantly more valuable than natural gas. I don't see any significant shift in capital allocation by the industry.
Most of the companies that are successful today drilling for natural gas are drilling for what we call wet gas or gas that has very high liquid content. That makes the net realized gas price close to $6/Mcf, rather than $4/Mcf because the liquid content lifts the value of the basket of products. That is attractive because these companies can replace gas in the ground for all-in costs of less than $2/Mcf. If total costs are less than $2/Mcf and the gas sells for $6/Mcf, margins are pretty good so there is a high return on the investment.
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TER: You have identified natural gas prices at the current level as a factor holding back Devon Energy Corp. (DVN:NYSE). What could this company accomplish with higher gas prices?
FG: The best use for natural gas is to put it in higher value-added products, for instance, to make it into fertilizers, to turn it into better chemicals, to turn it into a competing transportation fuel. We should leave LNG exports to developing countries. Industrialized countries, generally speaking, should not be exporting LNG. The U.S. should be selling manufactured products and value-added products, and that's how we could create jobs at home.
I don't think that the best thing for a company like Chevron is to put up a liquefied natural gas (LNG) facility at the cost of $10–20B and ship U.S. gas to Japan or Europe. I'd rather see the same gas converted in the U.S. into plastics and chemicals because it creates a lot more value and high paying jobs. That creates better economic returns than selling LNG.
TER: What is most exciting in your coverage universe?
FG: That has really changed. Right now, believe it or not, it is the refining and marketing side of the business, which has been in the doghouse for almost my entire career in this business. Changes around the world have created a unique cost advantage for the refiners in the U.S. because they have access to discounted crude relative to the global benchmark, Brent crude.
Most of the crude that comes from North America, whether oil sands in Canada or oil shale in the U.S., is landlocked. That makes it very attractive for the refiners in the midcontinent to take advantage of the abundance of a variety of crude oils and convert them into refined products. Refined product prices are based on Brent crude, so the manufacturing cost of the products is much lower in the U.S. than in any other part of the world. This, coupled with declining domestic petroleum demand, turned the U.S. from a net importer of gasoline to a net exporter of gasoline.
Two years ago, the U.S. was importing 1 million barrels/day (1 MMbbl/d) of gasoline on average. Now it is exporting 0.5 MMbbl/d of gasoline because of a combination of factors: People are driving more fuel-efficient cars and using mass transit, and economic recovery has been slow. Plus, the U.S. is substituting more and more gasoline with ethanol. That gives refiners in the U.S. an export window, which didn't exist before.
Refineries are using cheaper crude oil, which is a big cost advantage. Also, the refining industry is a very big user of natural gas. Lower crude and natural gas costs are a huge competitive advantage for the refiners in the U.S. In addition, turning from a net gasoline importer to an exporter has opened a window for these refiners to export their products to alleviate the oversupply in the U.S. market. They don't have to depress the price or the margin to sell the product.
Finally, the refining industry for the last 20 years or so has been spending an enormous amount of capital to meet environmental regulations. This is tapering off now, although it will always be there. Maintenance and environmental regulation spending will continue, albeit at much lesser rate than in the last 20 years. Refineries were spending 80% of their money to meet the regulation and to make sure that the facilities are maintained. The percentage now is less than 50%. They have 50% of their investment dollars in discretionary spending, so they allocate the cash to the project with the best return.
In addition, because of the free cash flow generation, these companies are spending less and are making more, so they have extra cash. They know that this won't last too long and therefore they are returning most of this cash back to the shareholders. That's why the stocks of the refining companies have significantly outperformed the market in the last two years. We're talking four to five times the average return in the market. Refining stocks gained 80% on average last year and about 30% so far this year, even with the recent correction. The refining industry has been a very bright spot in the energy sector in the last two years and that's a reversal from being the weakest link in the energy sector over the last 20 years.
TER: What are the benchmark oil price trends that investors should be watching?
FG: For the global market, it's Brent crude. Unfortunately, like all crude, global events affect Brent by concern over supply from the Middle East. This is not going to change. The world and most investors are worried that the increased ferocity in Syria and Iraq and the whole region could get wider and involve countries like Saudi Arabia, Iran and Egypt.
If we have a very big international crisis, oil prices are the barometer of how hot the situation is. Oil prices are likely to go higher regardless of economic activity or what happens to demand.
TER: Thank you for sharing your thoughts.
Fadel Gheit, an energy analyst since 1986, is a managing director and senior analyst covering the oil and gas sector for Oppenheimer & Co. He has been named to The Wall Street Journal All-Star Annual Analyst Survey four times and was the top-ranked energy analyst on the Bloomberg Annual Analyst Survey for four years. He is frequently quoted on energy issues and has testified before Congress about oil price speculation.
By. Tom Armistead of the Energy Report