Our outlook for energy stocks

China's growing importance as a global oil importer is obviously not a new trend, as China's thirst for oil has been one of the defining stories in the energy space for many years. What is new, however, is that China's oil needs are increasingly being met by Middle Eastern oil, increasing the country's interest in the region at the same time as the United States' need for Middle Eastern oil imports dwindles. This trend makes the recent events in Syria and Africa all the more important to China. Iran also remains a more long-standing concern with international sanctions keeping production at 2.7 million bpd in August 2013 versus 3.6 million bpd in 2011. In total, the recent unrest in these countries has removed almost 3 million bpd from the global oil supply. China is an interested observer with stakes in two of Syria's largest oil firms (via China National Petroleum) and a 50% stake in one of Syria's largest oilfields (through Sinochem), and it is one of Syria's primary trading partners. Recently, China (through   Sinopec  SNP also agreed to pay US$3.1 billion for 33% of   Apache's  APA Egyptian operations, agreed to loan Nigeria US$1.1 billion in exchange for up to 200,000 bpd of Nigerian oil by 2015, and already imports around 375,000 bpd of Iranian oil (China even received an exemption from the Iranian sanctions).

In Syria, the chemical attacks in the country are certainly disturbing, and the United States and Russia appear to have reached an agreement for Syria to give up its chemical weapons. While Syria is not a significant producer of oil (production levels were around 50,000-60,000 bpd recently, down from around 400,000 bpd prior to the conflict), but its location next to Iraq (3.2 million bpd), Kuwait (3 million bpd), Iran (2.7 million bpd) and Saudi Arabia (10 million bpd), along with the potential for any conflict in Syria to spread to its neighboring countries, is a concern for the oil markets. Russia and Iran are reported to be supplying weapons to the Syrian government, while Saudi Arabia and Qatar are supplying the rebels. Any U.S. military strike within Syria raises the risk of retaliatory attacks against Saudi Arabia and Qatar, further inflaming tensions. There are also pipeline geopolitics in play, as Syrian president Bashar al-Assad recently agreed to a deal for a pipeline to ship Iranian gas through Iraq to Syria, after previously rejecting a similar pipeline that would have shipped gas from Qatar--opening up a new export avenue for the country--through Saudi Arabia, Jordan and Syria, and ending up in Turkey. The Qatar pipeline was rejected because it threatened the natural gas interests of Russia, which happens to be a Syrian ally. We consider the risk of greater turmoil in the Middle East due to actions taken in Syria low, but any negative developments are likely to have an outsize impact on oil prices given the large amount of oil production involved.

In Africa, the Libyan success story appears over for now while the environment in Nigeria has worsened; we've seen a loss of 1.2 million bpd of production as a result. In Libya, after an initial rebound to 1.6 million bpd of production by mid-2012 from a low of 45,000 bpd in mid-2011, production now stands at around 100,000 to 250,000 bpd. There have been a number of strikes in the region, as workers angry at government corruption and low wages have targeted attacks on Libya's export terminals with great success. At this stage, the Libyan government has suggested that it will look to diversify its pipelines in the future, but there are no clear immediate short-term fixes. In Nigeria, oil theft (long a problem in the country) has accelerated recently, thanks to the government's inaction (and seeming complicity in many cases), causing current oil production to dip to 1.9 million bpd from over 2.1 million bpd in 2011.   Shell  RDS.A and   Eni  ENI, both large oil producers in the country, have been forced to shut in production because of sabotage. After years of frustration and limited governmental progress on a petroleum reform bill that could potentially introduce more attractive terms for the majors, Shell appears to be planning to sell several Nigeria acreage blocks as it moves to more attractive waters.

While there are some more dark clouds around the global supply outlook than just a few months ago, the global oil demand outlook looks more promising. OPEC, in its monthly oil market report, slightly boosted its 2013 global oil demand growth projection to 820,000 bpd from 790,000 bpd, while leaving its 2014 projections of global oil demand growth of 1.04 million bpd unchanged. U.S. oil demand growth remains essentially unchanged from 2012 levels, while there are signs that European oil demand will increase in future years owing to increased car sales in Germany, France, the UK and Spain. European oil demand is still expected to decline about 310,000 bpd in 2013 and 170,000 bpd in 2014 versus a 540,000 bpd decline in 2012. Demand from China and the Middle East also remained fairly healthy with 5% and 6% demand growth rates versus last year's levels.

Switching over to natural gas, we think the outlook for natural gas prices still looks promising. On the negative side, natural gas storage levels of 3,253 billion cubic feet (bcf) as of Sept. 6 are about 5% below 2012 levels, but recent storage injection levels have run close to and above the five-year average. For example, our last quarterly report noted that storage levels were 21% below last year's levels versus just 5% today. On a more positive note, U.S. dry gas production levels were around 66.3 bcf per day as of June, up about 1.4% from the prior year, sharply down from recent growth rates of 5% in 2012. In addition, the number of active U.S. gas rigs has ticked up to close to 400 active rigs from about 354 rigs in June, indicating that more rigs are needed to keep natural gas production levels flat. We consider this trend a signal that higher gas prices will be needed to grow natural gas production and drilling activity.

On the demand side, natural gas consumption was down 1% from 2012 levels as of Sept. 11, because of a decline in power and residential demand, but we think the overall gas demand picture looks different in 2020. By 2020, we project a 5 bcf drop in demand from the power generation market, but a 40% increase in petrochemical-related demand (as part of an overall 5 bcf per day increase in industrial demand), plus substantial demand growth from Canada, Mexico and LNG. In Canada, we expect that increasing demand in Ontario, declining gas production in the Western Canadian Sedimentary Basin and surging production growth from the Marcellus Shale will result in the displacement of Canadian imports through 2020. In Mexico, growing demand for gas cannot be met by the country's internal supply, meaning the U.S. will be called on to meet the supply gap. In total, we expect pipeline exports to drive an incremental 3 bcf in demand. Finally, we expect LNG exports to result in demand for about 10 bcf/d of natural gas by 2020. This forecast suggests multiple ways to win for investors interested in taking advantage of the stronger outlook for U.S. natural gas prices over the medium to long term.

Energy stocks for your radar

We have refreshed our list of recommendations this quarter with several new ideas. We've added   Devon Energy  DVN,   Canadian Natural Resources  CNQ and   Tesoro  TSO, while keeping long-standing favourites   National Oilwell Varco  NOV and   Ultra Petroleum  UPL. Devon has replaced Apache based on Apache's share price appreciation and the sale of Apache's 33% interest in its Egyptian operations, which we saw as a key catalyst. Similarly, Canadian Natural Resources has replaced   Suncor  SU, and Tesoro has replaced   HollyFrontier  HFC because of share price appreciation for Suncor and HollyFrontier.

	Top Energy Sector Picks
		Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
	National Oilwell Varco		$85.00	Wide	Medium	$59.50
	Ultra Petroleum		$40.00	Narrow	High	$24.00
	Devon EnergyParts		$87.00	Narrow	High	$52.20
	Canadian Natural Resources		$50.00	Narrow	Medium	$35.00
	Tesoro		$70.00	Narrow	Very High	$35.00
	Data as of 9-20-13

  National Oilwell Varco  NOV
National Oilwell Varco is in an interesting situation. In 2010, rig technology segment margins reached 30% as the firm benefited from delivering high-priced equipment ordered during the 2005-08 cycle during a cyclical lull in orders, which lowered the equipment delivery and associated costs for National Oilwell Varco. Today, National Oilwell Varco is delivering lower-priced equipment in a high-cost environment. For example, shipments from its Houston blowout preventer plant are expected to increase more than 80% in 2013.

Further complicating matters, demand for North American equipment is soft, while international and offshore demand is high, as evidenced by the $3 billion-plus in orders in the last quarter. In this environment, the company has underestimated the costs for adding capacity to meet demand, and rig technology margins have suffered recently as a result. The rig technology segment also must deal with the fact that Petrobras has capped the number of deep-water floaters it needs at 42 in 2016, and the firm is now unlikely to be a source of rig equipment orders for National Oilwell Varco in the near future. We estimate that about 30% of the company's backlog is made up of Petrobras orders, but a surge in jack-up and land rigs orders will help it replace the loss in orders, in our view. National Oilwell Varco also recently doubled its dividend, which is a plus.

  Ultra Petroleum  UPL
Ultra's Pinedale and Marcellus assets represent one of the best one-two punches in North American upstream. The company remains well positioned to take advantage of a secular recovery in natural gas prices, thanks to its low-cost structure and long runway for growth. Ultra's balance sheet could tighten further over the next few quarters as hedges roll off, but under current strip prices the company should be fine from a covenant perspective. A takeout offer from one of the majors or a larger independent could help fast-track value realization: As a company, Ultra is both scalable enough and "bite-size" enough to attract a wide range of suitors. If Ultra is acquired, its takeout price could exceed our fair value estimate on a stand-alone basis.

  Devon Energy  DVN
Devon has been one of the weakest-performing stocks in the U.S. upstream space over the past several quarters, thanks to a gas- and NGL-heavy production profile, underwhelming near-term growth prospects as a result of a slowdown in gas-directed drilling, and a handful of disappointments in oil-rich exploration plays that were supposed to drive the next leg of growth for the company. We think Devon's stock will continue to come under pressure as long as investors remain skeptical about the firm's ability to deliver oil and liquids growth and until additional steps are taken to highlight the underlying value of the company's assets. While we don't necessarily expect meaningful appreciation in Devon's stock price over the next few quarters, we think a plausible case can be made for the stock to be trading north of $85 by year-end 2015, implying close to 50% upside from today's price. Moreover, at less than $60 per share, the risk/reward ratio for Devon remains favourable, with approximately US$15 of downside and US$30 of potential upside in the name.

  Canadian Natural Resources  CNQ
Canadian Natural Resources is one of Canada's largest producers of low-cost natural gas and heavy oil/bitumen. Near-term headwinds include a bitumen emulsion leak at its Cold Lake project and ongoing transportation bottlenecks. We believe the emulsion leak will be resolved in time for the next steaming cycle, and transportation bottlenecks are already being addressed. Steaming at the initial phase of its first large-scale commercial steam-assisted gravity drainage (SAGD) project, referred to as Kirby, is underway with first oil expected in early 2014. By the middle of 2014 we look for Kirby to produce over 20,000 barrels per day of oil, increasing to 40,000 bpd by 2015. This is one of almost a dozen possible SAGD projects that contribute to Canadian Natural's 90 billion barrels of oil in place with expected netbacks (after royalties) of over $30 per barrel. In addition to its SAGD projects, its Horizon oil sands mine has been experiencing smooth operations following a planned turnaround, and we look for improved cash flow going forward.

  Tesoro  TSO
Over the long term Tesoro will benefit the most from the increased flow of inland U.S. and Canadian heavy crude to the West Coast. The firm is already transporting Bakken crude to its Anacortes, Wash., refinery, realizing a feedstock cost advantage relative to ANS as well as $4-$5/bbl in yield improvement. Eventually, Tesoro can replicate this success to a large degree throughout its California system, including its recently acquired Carson refinery. We do not think the market is properly crediting Tesoro for this potential uplift in earnings, cash flow and returns that is likely to occur over the next few years.

Please see our detailed take on each sector in the reports that follow.

•  Our outlook for the U.S. economy
•  Our outlook for the U.S. stock market
•  Consumer cyclical
•  Basic Material
•  Tech&Telecom
•  Consumer defensive
•  Health Care
•  Financials
•  Utilities