The price of crude has collapsed by 50% in a few months (and 40% since the end of QE3), which can only mean one thing: the Wall Street penguin brigade is out in full force with its spate of energy sector downgrades, none of which is more bombastic than that of Citigroup's Robert Morris who in 118 pages just crucified the entire energy space, lowering his target price for every single company in his coverage universe, and declaring that "Goldilocks has left the building."
The first question: what does it mean for the CapEx component of Durable Goods spending and core CapEx? Nothing good:
2015 Projected Budgets Now Down ~33%... – Although only seven out of 27 companies in our E&P coverage group have issued 2015 guidance (and we believe some will have to be revised), we now project total capital spending will be down ~33% (E&D down 26%), in aggregate, year over year in 2015
Even as companies rush to outproduce each other:
“Organic” Liquids Production Expected To Increase ~16% – Based on our revised cash flow and budget projections, total production for our E&P coverage group is now projected to increase ~9% this year (~11% “organic” adjusted for acquisitions and divestitures) versus ~14% previously with total reported oil/liquids production now projected to be up ~12% (~16% organic).
Leading to dumping and liquidations, and a collapse in EPS:
Estimates Drop Significantly… – On average for our E&P coverage group, 2015 EPS/CFPS estimates drop by ~57%/21% (and are now 50%/22% below Consensus) and for 2016 decline ~54%/23% (58%/22% below Consensus).
The punchline:
“Goldilocks” Era Comes To An End… – Over the past two years, the E&P sector has experienced unprecedented returns with strong commodity prices and ongoing efficiency gains throughout core North America shale and resource plays and no material increase in oil field services costs. However, this is a cyclical industry and the near-term outlook has turned quite dire. We are downgrading APC, CHK, COG, CXO, EPE, RRC, NBL, NFX, PXD and WLL to Neutral from Buy, and MRO, OAS and XEC to Sell from Neutral.
The details:
“Goldilocks” Era Comes To An End… – Just over one year ago (see our 12/12/13 2014 E&P Sector Outlook note), we projected that the “Goldilocks” era for the E&P sector was likely to persist through much of 2014 with ongoing drilling efficiency gains throughout key North American shale and resource plays and with no expectation for any material increase in oil field services costs. However, we did state that a drop in oil prices could yield some headwinds at times although oil prices rose through the first half of the year. We have covered the E&P sector for 20 years and during the first 18 years we emphasized that this was a margin business with E&P companies being ‘price takers’ – both of commodity prices and ultimately of oil field services costs. However, for most of 2013 and through the first threequarters of 2014, the E&P sector experienced margin expansion with an overbuilt oil field services sector unable to take away the ‘economic rent’ resulting from sharp efficiency gains in horizontal drilling and relatively strong commodity prices. Thus, E&P companies repeatedly stated that they were getting 100%, or better, rates of return from drilling wells in key shale plays such as the Eagle Ford, Bakken, Marcellus, Utica and Permian Basin.
…With The Inevitable Happening… – But drilling for oil and natural gas is a cyclical business. The result of unprecedented returns and virtually “free money” was that oil production in North America surged. And nearly everyone counted on Saudi Arabia and/or OPEC to cut production to sustain oil prices in a $90-100/Bbl range. But when Saudi said OPEC would not cut production, oil prices began to collapse. In our view, Saudi Arabia concluded that it was not in the business of continuing to lose market share in order to subsidize near $100/Bbl oil so that the E&P sector could continue to post unprecedented returns in boosting North America oil production at a circa 1.0 MMBbl/d/year, or higher, pace.
…And So Now It’s Back To The Basics… – While oil prices are likely to overshoot to the downside, the fact is that the core of most North America shale or resource plays still garner positive rates of return at $55-65/Bbl (our current WTI forecast for 2015 and 2016, respectively) especially with an anticipated drop in oil field services costs across the industry. A particular E&P company (EOG) comes to mind that prior to the past two years would hold an analyst meeting every year. During these analyst meetings, the company would have breakout rooms with their best three or four plays. And the company would outline that these plays were yielding 30% or 40% or 50% rates of return. Over the past two years though, this same company touted that it was posting 100%-plus rates of return in its three core growth plays. Today, we believe that if this same E&P company held an analyst meeting, at $55- 65/Bbl WTI, and with some expected drop in oil field services costs, it would claim that its three core plays would again post 30% or 40% or 50% rates of return.
…Wherein The Strong Will Survive – Cash flow per debt-adjusted share (CF/DAS) growth along with Reserve Replacement Efficiency (RRE) should continue to be the most highly correlated metrics to longer-term E&P share performance although recent volatility may skew this correlation near-term. Notably, as companies high grade drilling inventories and costs adjust, we believe returns will once again normalize. For the sector’s RRE to revert to the 15-year average of 1.8x given our current 2015 cash flow projections, average F&D costs would have to decline by ~32% (vs. 2013), which we believe will transpire. Overall, COG, AR, RRC, CHK and SWN have the highest projected CF/DAS growth through 2017, although our commodity price forecasts yield a bias for the more natural gas leveraged names, while on the more oil-leveraged side of the equation are CXO, NBL, EOG and PXD. These names also possess among the best assets to be able to high grade inventories with still positive returns in the current commodity price environment, in our view.
Here is his update price target table...
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The only problem is that it comes after reality has already set in. Morris' note would have been more useful had it come before these moves:
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So is this the bottom everyone is looking for? Perhaps, then again every single time the falling knife catchers have reached out in the past 6 months they have sevred at least one major artery. And while the Citi focus is, as usual, one of the supply-side, the real answer remains in the collapse in global demand much as neither the media nor Wall Street wants to admit it, as the entire world - first Japan, then Europe, then the BRICS - see economic growth collapse.
But the final flush will only take place when neither supply nor demand, but the de-financialization of crude takes place, in other words, when the WTI futures volume finally reverts to its long diverging mean from actual oil production, as discussed previously [17]:
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