ANALYST REPORT / Merrill Lynch - USA
Compliments of Strictly: Oil and Gas Exploration Companies Subject Location
Subject 22327
Merrill Lynch 1999 E&P Forecast/Analysis
30 December 1998
Next year, most E&Ps will have essentially ‘cleaned house'. The stocks will be starting ‘99 at historically low price and valuation levels.
On 12/10/98, we published a note in which we said that investors should expect more stock price volatility, more year-end writedowns and charges, reduced 1999 wildcatting and low organic growth. Well, given recent corporate announcements we'd say that was the case. As the year ends, many companies are playing a waiting game with respect to their own reserve valuation changes, but we wouldn't be surprised to see more writedowns or impairments but we don't expect a severe market reaction. The flip side to most companies marking their producing assets to market is that inter-company comparisons will prove to be more consistent.
Why be optimistic if prices are low?
Historically, the E&P sector has been cyclic and opportunistic. With lower oil field services costs, the E&P companies will be able to stretch their investment dollars. Plus, reduced capital access will cause most companies to live within their cash flow. So, as pointed out on 12/10/98, capital spending could drop 20% to 40% for the independents, and the U.S. upstream industry as a whole will have a large expenditure contraction. The net effects of reduced reinvestment are production and reserve declines. If our thesis about the shelf (see report published on 12/22/98 is correct, then reduced activity levels on the shelf and in other shorter lived reserve areas will cause production declines and better 2H99 gas prices. So, the investors who believe in the efficacy of oilfield drilling and service technologies will have to rethink their perspective about a secular change occurring.
What could derail our thesis?
More vulture funds have entered the E&P domain to shore up leveraged balance sheets. That situation reflects the differences between oilfield company balance sheets and those of the E&Ps. This type of capital might prevent attrition or business failures. Also, if we're wrong on the availability of producing properties, another wave of exploitation could occur a la the 1992 – 1994 period when U.S. gas output rose dramatically. However, given our view on current company prospect inventories, and a desire of property sellers to demand top dollar, we may not see that type of production response in 1999.n We don't believe that year-end tax loss selling will spillover into 1999. If anything, value oriented investors will see the positive side of companies being at or below asset value during a period of cyclic and low wellhead pricing.
There are many days in which we wish that our stocks had internet valuations (7/16/98), but that isn't reality. Should the investment community keep a belief in technology's ability to add marginal supplies and inventories stay high, then one will have to consider the rationale for a secular change. But, if these upstream companies are to generate economic investment returns as freestanding entities, they will need to have real earnings or have management teams willing to give up the helm at the right time when a purchase bid comes along if it makes sense for shareholders.
Production growth rate expectations should remain low on a going forward basis, and fiscal conservatism will stay in vogue.
Depending upon corporate strategies, production growth rates won't be sustained for the larger companies at high double digit rates if they are to keep their debt at reasonable levels. Aside from business diversification, one of the reasons the integrated stories have also worked in 1998 has been low debt service commitments. We think that the street will need to get away from projected multiples, and look more at asset values, long-term track records and management teams.
Table 1: E&P stocks to own and rationale
Company Ticker Rating Price Rationale
Anadarko APC C-1-1-7 $29 11/16 Quality discoveries.
Apache APA B-2-1-7 25 Balanced fiscally & in upstream .
Burlington BR B-1-1-7 35 15/16 Gas levered with good finances. Enron O&G EOG
B-2-1-7 17 1/16 Gas levered, & foreign assets.
Noble Affil NBL B-1-1-7 22 ¼ Fiscally sound, grow long-term .
Vastar Res. VRI B-2-1-7 42 1/8 Gas levered, good DeepH2O.
Devon Energy DVN C-2-1-7 28 7/8 A balanced NA gas E&P.
Newfield Expl NFX C-2-1-9 20 15/16 A consistent GOM grower.
Pogo Producing PPP C-2-2-7 12 11/16 Thai assets undervalued.
Cabot Oil COG C-2-1-7 15 1/4 Cheap, with long lived gas.
[OEI, PPP] MLPF&S or one of its affiliates was a manager of the most recent offering of securities of this company within the last three years. [DVN, HSE, SFR, SGO, XTO] MLPF&S was a manager of the most recent public offering of securities of this company within the last three years. [OEI] An officer, director or employee of MLPF&S or one of its affiliates is an officer or director of this company.
Opinion Key [X-a-b-c]: Investment Risk Rating(X): A - Low, B - Average, C - Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12 mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 -Reduce, 5 - Sell, 6 - No Rating. Income Rating(c): 7 - Same/Higher, 8 - Same/Lower, 9 - No Cash Dividend. Copyright 1998 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). |
