Integrated oil, E&P, and R&M trading update -- Key takeaways following week 1 of earnings season _ Goldman Sachs - January 29, 2006
We believe key developments during week one of earnings season supports our continued Attractive coverage view. The two key early conclusions we draw are that (1) poor organic reserve replacement by larger companies could lead to further M&A activity in 2006 to the benefit of potential consolidation candidates and (2) 2006 E&P cost inflation guidance has not been worse than expected. We continue to believe 2006 will be a year where investors further ratchet up long-term commodity price expectations to the benefit of sector valuations and stock price performance. We see 15% upside to peak valuations consistent with a $45 long-term WTI oil price and 50% upside to "super spike" adjusted peak values consistent with a $60+ long- term WTI oil price. The sector is now 15% above traditional "mid-cycle", which we think will continue to serve as a support level for oil equities.
KEY TAKEAWAYS FOLLOWING WEEK 1 OF EARNINGS SEASON
(1) Organic reserve replacement from larger companies not off to an auspicious start. Chevron's (CVX; IL/A) weak 40%-50% organic price-adjusted reserve replacement indication (i.e., excluding acquisitions/sales and adjusting for price effects on international reserves) as part of its 4Q 2005 earnings release and Repsol's (covered by Michele della Vigna and team in London; Not Rated) announcement last week that it was writing down 25% of its proved reserves does not get major oil company reserve replacement trends off to a very good start. In Chevron's case, this is the second straight year of sub-par organic reserve replacement. We have historically observed that many companies that have less than 100% organic reserve replacement even in a single year often look to make acquisitions (see Exhibit 1). Reserve replacement indications are likely to be forthcoming from the other US and European major oil companies over the next several weeks, which we see as a key leading indicator for the relative urgency large companies may have to make acquisitions in 2006. (Goldman Sachs International is acting as advisor to Gas Natural SDG in the proposed acquisition of Endesa, S.A.)
We think that the major oil companies that show 100%+ 2005 organic reserve replacement, if any, are likely to be the better near-term trade. Investors will likely be watching closely to see if ConocoPhillips (COP; Not Rated) or Exxon Mobil (XOM; OP/A) can show price-adjusted organic replacement results meaningfully better than Chevron's. Both are expected to provided initial 2005 reserve indications in the next several weeks, with Exxon Mobil potentially making a comment during its 4Q 2005 earnings results to be released on January 30.
(2) 2006 E&P cost inflation guidance is not worse than expected. Many on the Street, including us, had expressed concern that 2006 E&P unit cost inflation guidance due to be released by most companies during 4Q 2005 earnings results could be even worse than our base-line expectation for a 15% year-over-year increase. While 2006 inflation could yet turn out to be well above our 15% starting point, we are relieved that the initial guidance from several E&P companies has not been meaningfully different from our expectations. While we have in several cases had to lower our previous 2006 EPS forecasts, the reasons were generally related to tax rate changes and other company-specific issues which we would distinguish from the broad macro concern of general E&P unit cost inflation. We also have tweaked down our 2006 Henry Hub spot natural gas price forecast to $9.50/MMBtu from $10/MMBtu previously to account for the weaker inventory outlook as a result of the exceptionally warm weather that we have been experiencing.
(3) Investors likely to ratchet up long-term commodity price expectations in 2006. We continue to believe that investors are likely to further ratchet up long-term energy commodity price expectations in 2006 to the benefit of sector valuations and stock price performance. In several notes over the past few weeks we had referred to this as "multiple expansion". However, after some reflection we think we should really be calling this "higher assumed long-term commodity prices"--more of a mouthful to be sure, but a more accurate description of the message we are really trying to convey. We estimate the sector has 15% upside to valuations consistent with a $45/bbl long-term WTI spot oil price and a $6.50/MMBtu Henry Hub spot natural gas price. However, with long-dated energy prices pushing $60+ for WTI oil and $8+ for Henry Hub natural gas, we think there is material additional upside for the sector. Though calculated differently, we find our "super-spike" adjusted peak values, which show 50%+ upside for the sector, happen to be consistent with longer-term $60+/bbl oil and $8+/MMBtu gas price assumptions.
NO CHANGE TO TOP PICKS OR RELATIVE RANKINGS, THOUGH WE CONTINUE WE CONTINUE TO BE INTRIGUED BY "VALUE"-ORIENTED E&Ps.
--Oil leveraged E&Ps/domestic integrateds.
Our favorite oil-leveraged E&Ps/domestic oils include Canadian Natural Resources, Suncor Energy, and Murphy Oil (all OP/A). Canadian Natural and Suncor in particular, given their long-lived oil sands exposures, would be among the biggest beneficiaries to a view that long-dated oil prices are sustainably higher. For Murphy, we are anticipating drilling results for four medium-risk/medium-potential wells offshore Peninsular Malaysia to be announced any day now. We think success on at least two of these wells could be positive for its share price.
--US gas leveraged large-/mid-cap E&Ps.
Our favorite large-cap gas E&Ps remain XTO Energy followed by EnCana (both OP/A). Among mid-cap E&Ps we favor Southwestern Energy and Newfield Exploration (both OP/A). Of those four, XTO, EnCana, and Southwestern are all so-called "visible growth" E&Ps, given their respective large exposures to key unconventional gas resource plays onshore North America. While we continue to have a favorable fundamental view of all four companies and there is no change to our OP/A ratings at this time, we continue to be intrigued with "value"-oriented E&Ps like Anadarko Petroleum, Noble Energy, and Pogo Producing (all IL/A). Other large-/mid-cap value E&Ps that have increasingly attractive relative upside are Apache and Devon Energy (both IL/A), but we would rank these two behind Anadarko as we think Anadarko has more visible catalysts this year in terms of expected production growth and other company-specific events.
--Small-cap E&P.
Bill Barrett is still the OP/A-rated and growth-oriented top pick. However, we continue to see Forest Oil's (FST; IL/A) risk/reward as very favorable and it increasingly may have better near-term catalysts than Bill Barrett, making it a very close call in terms of which stock we prefer. In Forest's case we see the coming spin-off of its Gulf of Mexico assets into the soon-to-be-publicly-traded Mariner Energy as a positive event. An upcoming analysts meeting in mid-March could highlight the "new" Forest to the Street. (Investment funds affiliated with The Goldman Sachs Group, Inc. have a principal investment in Bill Barrett Corp. (BBG). As a result of its position in BBG securities, The Goldman Sachs Group, Inc. may be deemed an affiliate of BBG.)
--Refining and marketing.
Valero Energy (VLO; OP/A) remains our top pick. With Valero now trading near our $61 "traditional" peak value, further upside is dependent on investors ratcheting up long-term refining margin expectations. Given our bullish outlook for 2006 refining macro conditions, we think it makes sense to stick with Valero as an OP/A-rated top pick at the current time.
--Super-cap integrated oil.
We continue to view Exxon Mobil (XOM; OP/A) as the superior low-beta portfolio balancer to our high-beta E&P, domestic oil, and R&M favorites highlighted above. The super-cap oils have been big laggards during this upcycle as the superior commodity leverage exhibited by other companies in the sector, a deterioration in company fundamentals for several super majors, and previously premium valuations have kept the group under relative pressure. Given our bullish commodity macro outlook, we think it makes sense to stick with our preference for high-beta E&Ps, domestic oils, and R&Ms. However, the super-cap oils look to be due for a bit of catch-up rally at some point in the next several months. We think that whichever major oil company(ies) can show better 2005 price-adjusted organic reserve replacement will be the ones to move up the most in the near-term.
Goldman Sachs & Co. and/or one of its affiliates is acting as financial advisor to ConocoPhillips in the proposed acquisition of Burlington Resources Inc. Goldman Sachs & Co. and or one of its affiliates will receive a fee for its financial advisory role. 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. Goldman Sachs & Co., and or one of its affiliates, is acting as advisor to Talisman Energy Inc. in the proposed offer for Paladin Resources PLC.
Anadarko Petroleum Corp. (IL/A, $107.14), Apache Corp. (IL/A, $71.36), Bill Barrett Corp. (OP/A, $38.06), Canadian Natural Resources Ltd. (OP/A, $59.94), Devon Energy Corp. (IL/A, $65.46), EnCana Corp. (OP/A, $47.11), Exxon Mobil Corp. (OP/A, $61.29), Forest Oil Corp. (IL/A, $50.71), Murphy Oil Corp. (OP/A, $56.20), Newfield Exploration (OP/A, $49.82), Noble Energy (IL/A, $44.40), Pogo Producing Company (IL/A, $57.96), Repsol YPF (NR, EUR22.17), Southwestern Energy Co. (OP/A, $40.90), Suncor Energy Inc. (OP/A, $78.73), Valero Energy Corp. (OP/A, $60.05) and XTO Energy Inc. (OP/A, $47.99)
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, Luis Ahn. |
