As North America continues to produce more oil and gas than the world knows what to do with, Raymond James Analyst Andrew Coleman thinks the sector is likely to remain sluggish. But if investing is a bit of a poker game, you need to learn to read the table if you want the best chance at a winning hand. In this interview with The Energy Report, Coleman explains the international supply/demand disparity and tells us which oil and gas producers he values highest in an uncertain energy market.
The Energy Report: We are at the end of Q1/14; how is the oil and gas space faring?
Andrew Coleman: Overall, the space was helped by stronger domestic gas prices as we came out of the cold winter. The Q1/14 numbers have not been fully reported yet, but gas prices were up to $5 per thousand cubic feet ($5/Mcf) at bid week. As a result of this increase, a number of gas-weighted exploration and production (E&P) companies outperformed the market.
TER: What changes do you see on the table for Q2/14?
AC: From the macro standpoint, we at Raymond James have been asking ourselves, "How and when will gas storage begin to replenish?" The answer to that question will dictate how the gas market reacts during the next three to six months. Clearly, the strength of the winter weather sales and the reduction in storage levels make us much more positive on 2014 gas prices than on 2015 gas prices. We think there will be enough coal switching to keep gas prices from getting too frothy. We also believe the E&P industry's ability to bring new supply to the system will help close the storage gap. So, while we recently increased our 2014 gas price deck, we left 2015 unchanged.
TER: Are we looking at a global glut for oil and gas?
AC: That's certainly been the sentiment at Raymond James for the last 24 months. Supply coming from the North American shale plays has overshadowed demand growth. The market remained tight last year due to supply curtailments made by the Organization of Petroleum Exporting Countries (OPEC) in the Middle East. And in the months to come, I think we'll continue to see growth in North American production volumes and a trend toward oversupply, with the first pricing disruption coming from a widening Brent/LLS spread.
TER: What role are the Saudis and Chinese playing in the current oil and gas environment?
AC: Prior to the shale oil development boom, there was one marginal producer of oil—Saudi Arabia—and one marginal buyer of oil—China. However, the discovery of U.S. shale oil deposits introduced the country as a second marginal supplier. It is our view that Saudi Arabia will cut oil production to keep the market balanced, but there's a question as to how much the Saudis will cut. The recent Saudi cut of 1 million barrels of oil per day was more than we expected in the short term. Will it cut more? A part of the answer depends upon the health of China's growth trajectory, as the country's slowed progress has given way to concern for the robustness of its oil demand.
TER: Will the North American shale fields keep producing for the long term?
AC: Raymond James recently published an article that attempts to answer that question, analyzing the Bakken Shale. We used our type-curve models to forecast what it will take on a rig count basis to get Bakken production to slow its growth rate. The report shows that the rig count would have to be cut by more than 50% in order for production to show a noteworthy decline. Growth is being driven by a combination of pad drilling (e.g. faster cycle times) and downspacing (e.g. higher-density drilling).
It used to take 60 days to bring a new well online in the Bakken, but now, the average time is half that. And even if the productivity of the rock in the basin is declining, producers don't have to deal with infrastructure bottlenecks, such as transportation issues. Roads and other infrastructure were built throughout the Bakken during the first few years of the boom and those efficiencies are helping to offset any potential risks to reservoir productivity at this point. That scenario is likely to continue through the end of this decade.
TER: In your previous Energy Report interview, you discussed a number of exciting North American E&P companies. What are some of the names you're following today?
AC: EOG Resources Inc. (EOG:NYSE) is the best run and most respected E&P company out there. It's been my Top Pick for some time because it has a great balance sheet and the fastest growing large-cap E&P profile in the sector and the stock certainly reflects these strengths. It's a dominant player in the Eagle Ford play, where it has experienced huge growth. It's also one of the pioneers in the Bakken and is testing acreage in the Permian Basin. Given that Raymond James' commodity outlook for the next two years models West Texas Intermediate (WTI) oil moving toward $75/barrel ($75/bbl), I see EOG as a great defensive name. It offers good production growth on a debt-adjusted basis.
TER: Do you think the stock is an attractive buy at the present time?
AC: Absolutely. It's hard to argue with the company's level of execution. Considering our overall risk aversion at Raymond James, EOG is a best-of-breed at almost any size market cap.
TER: What's the main way that Raymond James factors risk into commodities analyses?
AC: The risk is that we are pricing WTI in the mid-$70/bbl range next year. The Bakken and midcontinent supply puts pressure on the Brent and WTI spread.
TER: Is that what makes Raymond James risk averse?
AC: Yes, that supply environment makes us cautious on E&Ps. We aren't as cautious as we were two years ago, when we thought the WTI would drop to $65/bbl, but we're still cautious, and we are not seeing enough growth on the demand side to offset that risk.