Integrated oil, E&P, and R&M trading update -- Sell-off creating attractive re-entry point - Goldman Sachs - October 17, 2005
We believe the healthy pull-back in integrated oil, E&P, and R&M equities is creating another re-entry/buying opportunity for investors, with the sector now showing 28% upside to traditional peak valuations. In our view, fears of demand destruction are misplaced, as we believe a lack of supply availability has forced lower demand. As supply is brought back online in coming weeks/months, we believe demand will return and with it investor enthusiasm for the sector. The group sell-off has been across the board, and we think an eventual recovery will likely similarly benefit the sector broadly. With that said, we highlight five of our top picks as looking particularly attractive today: Amerada Hess, Murphy Oil, Newfield Exploration, Valero Energy, and XTO Energy (all OP/A). Occidental Petroleum remains Not Rated. (Goldman Sachs & Co., and or one of its affiliates, is acting as financial advisor to Occidental Petroleum Corporation in the proposed acquisition of Vintage Petroleum Inc. Goldman Sachs & Co., and or one of its affiliates, will receive a fee for its financial advisor role.)
DEMAND DESTRUCTION FEARS MISPLACED, IN OUR VIEW
We believe healthy profit taking combined with investor fears over "demand destruction" has driven the sharp correction the sector has experienced over the past two weeks. The supposedly destroyed demand investors seem most concerned about relates to the negative year-over-year implied gasoline demand growth shown in weekly Department of Energy statistics since Hurricane Katrina hit. Given that 2-3 million b/d of refining capacity has been off line as a result of Hurricanes Katrina and Rita, the rest of the country's refining capacity was already running at full utilization levels, and increased import flow has not been enough to compensate for the downed refineries, we believe gasoline demand was forced down by lack of available supply. US gasoline demand, in fact, we think has been remarkably strong in light of the sharp increase in retail gasoline prices. We believe that as refining capacity is brought back online and supplies made available, observed gasoline demand growth will resume. We believe a reduction in energy demand would be a concern only if combined with supply growth, which is not the case today. Please see our oil sector trading update note from October 9, 2005 for additional comments on our views about demand destruction.
BALANCE SHEET HEALTH SHOULD DRIVE STOCK BUYBACKS, DIVIDEND INCREASES, AND M&A
Industry balance sheets appear to be as healthy as has ever been the case, certainly in the last 20 years. In the absence of stepped up stock buyback programs, dividend increases, or M&A we project that in 2006 net debt-to-tangible capital ratios for the sector will approach levels where cash on the balance sheet approximates debt, i.e., net debt free status. Invariably actions will be taken by some if not most companies to utilize excess cash. We believe the first priority for most companies will be to seek out attractive investment opportunities either organically or through M&A. As such, large increases in stock buyback programs or dividends may not occur until midway through 2006 when cash really starts to build up on balance sheets. However, weak stock price performance could inspire some companies to start buying back stock sooner.
Continuing a trend of steady M&A activity across the industry, last week Occidental Petroleum (OXY; NR) announced a friendly acquisition of Vintage Petroleum (VPI; NC) for a combination of cash and stock. Vintage's assets appear to be a sound strategic fit with Oxy's and financially the deal appears to make sense (see our October 14, 2005 note on Occidental Petroleum for more details). We expect to see additional acquisitions of smaller E&P companies by larger E&P and integrated oils in coming months and quarters.
CONFUSING 3Q RESULTS LIKELY ALREADY DISCOUNTED IN SHARE PRICES
The two catastrophic hurricanes, divergent trends in regional benchmark prices/margins, uncertain volume impacts from storm losses, and other one-time storm-related costs could conspire to make 3Q 2005 results particularly volatile relative to expectations. Investors should be prepared for companies to show wide variances with the First Call consensus, which in some if not a number of cases could be to the downside. We believe the risk of uncertainty in 3Q 2005 EPS performance is increasingly discounted in oil equity valuations given the sell-off in the shares.
10%-15% OFF SALE CREATING A GOOD RE-ENTRY POINT FOR SECTOR, WITH AHC, MUR, NFX, VLO, AND XTO OUR VERY TOP PICKS; OXY IS NOW NOT RATED
We believe the risk/reward for the sector overall is much improved, with Amerada Hess, Murphy Oil, Newfield Exploration, Valero Energy, and XTO Energy being our very top picks and a sixth stock Occidental Petroleum now Not Rated. For the sector overall, we estimate 28% total return upside to traditional peak valuations and 70% upside to "super spike"-adjusted peak values.
It is not our strength to try and time ultra-short-term tops, and bottoms in the sector and oil stocks could certainly correct further from here. We are still in the "shoulder months" between peak winter and summer demand and, with a number of refineries still down, the negative implied gasoline demand statistics could continue for several more weeks if not months, keeping pressure on the group to the extent that is an investor concern. We note that thus far the group has experienced a rather normal albeit somewhat faster 10% correction relative to the S&P 500, consistent with past pull-backs. However, given that the rally from mid-May lows to late September highs was a particularly strong 55%, well ahead of the previous typical rallies of around 30% before the typical 10% correction, it is possible that the pull-back this time could be a bit worse than the normal 10% hit relative to the S&P 500.
Amerada Hess (AHC; OP/A). We continue to believe that Amerada Hess's fundamental turnaround is on track and that its shares should not trade at a discount to its domestic oil peer group. Based on our base-case $68/bbl forecast for West Texas Intermediate (WTI) spot oil, we believe Hess will earn $22 per share in 2006. Hess shares are currently trading a just 3.3X 2006E EV/DACF, which we believe is an unwarranted discount to the 4.3X average 2006E EV/DACF valuation for the domestic oil sub-sector.
Murphy Oil (MUR; OP/A). Murphy shares have been among the weakest performers over the past 3-6 months, as a lack of exploration news and concern over its Meraux (near New Orleans) refinery and related oil spill during Hurricane Katrina have driven the stock to a discounted valuation from what was a premium valuation. We believe Murphy Oil has among the most attractive asset bases of any of the domestic oil or E&P companies we cover, as highlighted by its attractive deepwater E&P assets offshore Malaysia, in the Gulf of Mexico, and offshore Congo. The recently announced acquisition of Spinnaker Exploration by Norsk Hydro and the earlier purchase of EnCana's deepwater Gulf of Mexico acreage by Statoil serve to highlight what Murphy's asset base could be worth. While we continue to recommend Murphy as a going concern, we note that applying recent transaction valuations to its various E&P and R&M assets would correspond to an $85-$90 per share net asset value, well above Murphy's current mid-$40s stock price. With the exploration program not expected to result in news flow until 1Q 2006 as well as ongoing concern over the oil spill at Meraux (which we do not believe will result in a material hit to the company's financials due to insurance coverage), some patience may be required. However, with Murphy trading at a 2006E EV/DACF valuation of 4.1X, below the domestic oil and large-cap E&P average of 4.5X, we believe its shares are very undervalued.
Newfield Exploration (NFX; OP/A). Could Newfield be the next EOG? While we think it is premature to declare the Woodford Shale the next Barnett Shale, the fact that Newfield's historically ultra-conservative management has pegged the Woodford as offering 2-4 Tcfe of net natural gas resource exposure suggests investors should not wait too long to start buying Newfield shares. We note that Newfield management's stated Woodford Shale potential would correspond to roughly 100%-200% upside to Newfield's existing proved reserves. We had been optimistic on the outlook for Newfield shares even prior to the Woodford Shale comments made at its October 11 Houston analysts meeting (see our October 6, 2005 report on Newfield Exploration, "Growth visibility improved"). We had thought Newfield's current 2006E EV/DACF valuation of 4.2X should reach the E&P peer average valuation of 5.1X. To the extent Woodford upside resource estimates pan out and the company continues to execute on the rest of its E&P investment program, it is not impossible for Newfield to trade to a premium EV/DACF valuation, similar to what has occurred with EOG over the 18 months. In the case of EOG, it went from trading at a "conventional" E&P multiple to a premium "unconventional/visible growth" E&P valuation (EOG currently trades at 5.5X 2006 EV/DACF) as confidence in its Barnett Shale position grew.
Valero Energy (VLO; OP/A). We estimate Valero could earn on the order of $17 per share in 2006 based on our base-case $10/bbl Gulf Coast 3:2:1 refining margin assumption. With the stock currently trading at a 2006E EV/DACF valuation of just 4.5X, we believe significant stock price upside exists. For the R&Ms, beyond the ongoing tightness in capacity that was highlighted by the two catastrophic hurricanes, 2006 is still supposed to be a year where the allowed sulfur content in US gasoline and diesel is to tighten meaningfully. While it is possible that environmental regulations are weakened to ease upward pressure on gasoline prices, we believe the fact that at some point the new rules will be enforced argues at a minimum for greater cycle duration.
XTO Energy (XTO; OP/A). XTO Energy appears to have lost some measure of its previous investor appeal, as the stock has not been leading the gas E&Ps up over the past several months. The stock price malaise appears to be a function of investor questions as to whether XTO can continue its strong track record of leading growth and returns given its now much expanded size. In addition, questions over executive compensation appear to be adding to investor unease. Irrespective of whether one believes XTO's executive compensation is excessive or not, we believe the company's strong track record of growth and returns cannot be disputed and we believe it is extremely well positioned to take advantage of what we believe will be robust US natural gas prices during the coming winter months and into 2006.
Occidental Petroleum (OXY; NR). We believe "oily" names like Occidental Petroleum have lagged the sector in recent weeks, as the hurricanes benefited refining margins and US natural gas prices to a much greater extent than crude oil prices. Oxy shares fell a further 3% on October 14 (versus a generally up day for the group) on the heels of its announced acquisition of Vintage Petroleum. In our view, Oxy's acquisition of Vintage makes both strategic and financial sense and we continue to view favorably its leading Middle East position. We believe Oxy is on track for leading growth and returns among large-/super-cap companies, as we project mid-single-digit visible organic growth over the next five years and top quartile returns on capital employed (ROCE). However, Oxy currently trades at a 2006E free cash yield of 15% and at a 2006E EV/DACF valuation of 3.7X, both of which are prior to the Vintage deal which we expect to be accretive to its earnings, cash flow, and free cash flow. By way of comparison, the domestic oil and large-cap E&Ps on average are trading at an 8.5% 2006E free cash yield and at a 2006E EV/DACF valuation of 4.5X. We note that the average domestic oil and large-cap E&P has some combination of lower projected growth, ROCE, or free cash flow than Oxy.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Brian Singer. |
