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Morningstar | Incorporating Lower Near-Term Prices: Upstream Oil and Gas Valuation True-Up

We have refreshed the fair value estimates for our upstream oil and gas coverage after incorporating meaningfully weaker crude prices. To be clear, there is no change in our midcycle price forecasts--$55 per barrel and $60 per barrel for West Texas Intermediate and Brent, respectively. But after the recent slump, we are factoring in lower prices in the near term, and that alone is enough to dampen valuations across the sector.

WTI crude closed at $46 on Dec. 18, extending a rout that has now wiped off almost 40% of the benchmark's value in about two months. At that level, investment is likely to fall far short of what's necessary to keep pace with demand growth over the next few years, so prices must recover sooner or later. But in the short run, uncertainty abounds. It's possible that steep declines are still on the way for Iran, due to sanctions, and Venezuela, due to mismanagement of the economy (not to mention Angola, Libya, and Nigeria). On the other hand, current prices are likely to spur more demand growth than we were previously expecting. The bottom line is that undersupply and oversupply are both plausible outcomes next year, and making a directional bet on short-term crude prices is risky.

Instead, we focus on the midcycle price and activity level that keeps U.S. output in lockstep with the "call on the U.S." For shale producers, collectively the global swing producer, the marginal cost is around $55/bbl. Though prices have now reached this level, the U.S. rig count still exceeds the Goldilocks level that balances the market in the next five years (by at least 150 rigs). Therefore, shale producers must make further curtailments to avoid excessive production growth, which means 2019 budgets will be telling. If management teams take current prices as a signal to dial back, we could see prices stabilize near midcycle levels. But if producers are willing to carry on regardless, prices could collapse further before they improve.