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Dave Meats
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Morningstar | Most E&Ps Undervalued After Oil Price Slump; Our Top Picks Are Diamondback, Pioneer, and Laredo

West Texas Intermediate crude oil has fallen from over $65 a barrel in late April to about $54/bbl today, a hair below our midcycle forecast of $55/bbl. The slump has dragged most exploration and production stocks down with it, with 22 of the 23 names we cover now trading below our fair value estimates. The median and mean discounts are 12% and 16%, respectively. We see more upside than that for industry cost leaders like Diamondback Energy and Pioneer Natural Resources, which are better positioned to tolerate weaker prices. And while much-misunderstood Laredo Petroleum does not belong in the same club due to its less favorable acreage and weaker margins, it is even more heavily undervalued after the recent sell-off.

The decline in crude prices has erased most of the gains from earlier in the year, when fundamentals were supported by strong compliance with steep OPEC cuts. Indeed, OECD oil inventories plunged in February and March (the most recent months with reported data). But debottlenecking in the United States has since enabled shale producers to resume their rapid growth, while trade fears increasingly threaten to stymie demand. In May, the International Energy Agency reduced its 2019 growth forecast by 90 thousand barrels per day, just shy of the 100 mb/d impact that Rystad Energy attributes to the worst-case scenario where tariffs are applied to U.S. and China trade volumes. Meanwhile, U.S. inventories have surged in the last three months, culminating this week with a 17 thousand-barrel build--a contrast to the seasonal draw expected. OPEC is likely to extend the cuts when they expire in June, with or without Russian support. However, this won’t be enough to sustainably drive up prices beyond our midcycle forecast (as shale producers can compensate with higher activity levels during periodic upswings).

Nevertheless, we still think the segment is undervalued. In the last few years, U.S. E&Ps have adjusted to generate free cash flows with WTI at $50-$55, and a handful--the narrow-moat-rated cost leaders with the juiciest acreage and the savviest technical teams--can generate excess returns on invested capital as well. Diamondback Energy and Pioneer Natural Resources fall into this bucket. Both operate exclusively in the Permian Basin, which is characterized by strong initial production rates and a favorable oil mix. These firms are among the largest independent operators in the basin, which helps with logistics in the field and enables them to extract favorable terms from midstream and service industry partners. At current prices, these stocks are both roughly 20% undervalued.

Laredo Petroleum is also a Permian Basin pure play, but the stock doesn’t have the same shine since the firm’s acreage is less favorably located on the outer edge of the play (away from the traditional "sweet spot"). So it stands to reason that the market is more lukewarm on the name. However, due to fixable operating issues, the current discount is way overdone, in our view, making this one of the most compelling ideas in the upstream segment with over 100% upside. At this level, the stock bakes in no improvement in well performance whatsoever from 2018 levels, even though management has adjusted its strategy and has reverted to a wider spacing pattern (similar to what it used in 2016, when well performance was consistently better). In addition, we note that while meaningfully undervalued, Laredo has decent financial health, substantial downside protection via hedging, and can achieve 4% annual production growth within cash flows under midcycle conditions. For details, see "Laredo Petroleum Deeply Undervalued After Prolonged Sell-Off."
Underlying
Occidental Petroleum Corporation

Occidental Petroleum has three reporting segments: oil and gas, which explores for, develops and produces oil and condensate, natural gas liquids (NGL) and natural gas; chemical, which mainly manufactures and markets basic chemicals (chlorine, caustic soda, chlorinated organics, potassium chemicals, ethylene dichloride, chlorinated isocyanurates, sodium silicates and calcium chloride) and vinyls (vinyl chloride monomer, polyvinyl chloride and ethylene); and marketing and midstream, which purchases, markets, gathers, processes, transports and stores oil, condensate, NGL, natural gas, carbon dioxide and power.

Provider
Morningstar
Morningstar

Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offer an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors.

Morningstar provides data on approximately 530,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than 18 million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. Morningstar also offers investment management services through its investment advisory subsidiaries and had approximately $185 billion in assets under advisement and management as of June 30, 2016.

We have operations in 27 countries.

Analysts
Dave Meats

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