Our outlook for energy stocks

On the oil demand side, we remain more cautious. The Middle East is probably the biggest bright spot, with oil demand projected to increase 300,000 bpd in 2013, helped by a 7% increase in Saudi Arabian oil demand, thanks to industrial and transportation demand. In fact, Saudi Arabia is probably one of the more unheralded oil demand stories over the past decade, as it has doubled its oil consumption to about 3 million bpd in 2012 from 1.5 million bpd in 2000. Furthermore, in Europe, oil demand only declined 300,000 bpd in the first quarter versus a 500,000 bpd drop in the prior year, which is a positive.

Yet, the good news ends there, as the European economic issues still remain as difficult as ever to solve, meaning we're braced for further declines. The European Central Bank kept its interest rate at 0.5% recently after cutting it earlier this year from 0.75%, citing prospects for an economic recovery later this year. ECB President Mario Draghi lauded the bank's moves as "probably the most successful monetary policy measure undertaken in recent times," contrasting the bank's success at shrinking its balance sheet without causing market volatility compared to the U.S. Federal Reserve's measures, which have caused considerable market angst. We note that the ECB's optimism seems to fly in the face of recent trends, as the Organization for Economic Co-operation and Development (OECD) cut its global 2013 GPD estimate to 3.1% from 3.4%, primarily because of weakness in Europe. The OECD now thinks that European GDP will decline 0.6% in 2013 versus a prior projection of a 0.1% decline. In addition, the European unemployment rate per EuroStat increased one percentage point from a year ago to 12.2%. Before the meeting, investors were hoping that the ECB would cut rates again, as it had been hinting it might do for months. However, Draghi said that the ECB will stand ready as events dictate, indicating that it was "technically ready" to take deposit rates negative if needed. In short, the European picture remains very stagnant.

In China, the outlook continues to be grim. Chinese GDP growth for the first quarter was about 7.7% versus the 8.1% expected, and 7.9% in the fourth quarter of 2012. The OECD cut its 2013 GDP growth forecast for China to 7.8% from 8.5%, but we think a slowdown in investment spending could cause GDP growth to drop to just 5% in the next few years. Apparent oil demand also sharply dropped off with just 2% year-over-year growth in demand in March, versus 4.3% demand growth in the first two months of 2013. Overall, OPEC expects Chinese oil demand to increase about 350,000 bpd in 2013; a figure that we worry could be lowered as growth continues to slow.

With a surging supply and tepid demand, OPEC is starting to notice, as events could ultimately threaten OPEC's importance to the global oil markets. Two recent events caught our eye. First, OPEC decided to shut down a committee that monitors its members' compliance with oil-production targets, while maintaining its collective production ceiling at 30 million bpd. OPEC has set quotas at a group level since December 2011, and thus it no longer sees a need to maintain a committee to monitor individual quota levels. Axing the committee absolutely makes sense in our eyes, but it confirms the fact that tension among committee members over quotas, particularly among Iran, Iraq and Saudi Arabia, given their very different production outlooks, are close to irreconcilable. Second, OPEC signaled that it is growing more uncomfortable with the U.S. production outlook by starting a study into the effect of growing tight oil production on the global markets for OPEC crude. The concern is quite real, as OPEC crude oil imports into the U.S. were as high as 5.8 million bpd in August 2008, but only stand at 3.6 million bpd as of March 2013. As a result, OPEC needs to reallocate its barrels elsewhere (increasingly China), but also needs to maintain supply discipline in a more challenging environment.

While OPEC's situation remains murky, we're confident that the new North American oil dynamics have accomplished one thing: U.S. refiners HollyFrontier HFC, Marathon Oil MRO, Phillips 66 PSX, Tesoro TSO, Valero Energy VLO and Western Refining WNR now have narrow economic moats. Historically, we've thought of refining as a no-moat business because of its lack of control over the price of inputs and outputs, which made the business dependent on difficult-to-forecast and volatile spreads. However, the emergence and sustainability of crude discounts (WTI spreads versus Brent have blown out to $17 per barrel in 2012 from $1 per barrel in 2010) have given U.S. refiners a feedstock cost advantage, placing it lower on the global cost curve. Given that the U.S. is unlikely to pursue wide-scale crude oil exports in the future, we think the discounts (which imply an essentially stranded crude market for refiners) and thus the cost advantage will persist, earning U.S. refiners moats.

Staying within North America, we now look at the natural gas outlook. In short, the environment today appears to be one of average demand coupled with a weak supply picture, helping natural gas prices. We've returned to a more normalized demand environment for natural gas following the abnormally warm winters of 2011-12. For example, cumulative monthly heating degree days from November 2012 to March 2013 were 26% higher than comparable numbers in 2011-12. At the same time, natural gas storage levels stand at 2,252 billion cubic feet (bcf) as of May 31, 616 bcf below (or 21%) last year's levels and 69 bcf below the five-year average. Natural gas consumption is expected to increase to 70.2 bcf per day in 2013 from 69.6 bcf, as per the EIA, while dry gas natural production levels have declined year over year in two out of three months of data we have so far for 2013. Also, natural gas drilling activity continues to decline, and as of June 7, the Baker Hughes natural gas drilling rig count stands at 354 rigs compared with 407 active rigs three months ago. Accordingly, natural gas prices have responded to the increasingly positive outlook, more than doubling from early 2012 levels to around $4 per thousand cubic feet (mcf) as of early June. We still see more upside in the future toward our $5.40 per mcf long-term price deck, and substantial upside for natural gas weighted producers as well.

Energy stocks for your radar

We are keeping our list of recommendations largely unchanged this quarter with most of our old favourites returning. Because of share price appreciation, Occidental Petroleum OXY has been replaced with HollyFrontier. We consider HollyFrontier a timely recommendation given our recent moat upgrade, and we'd also highlight its decent-size discount to our fair value estimate as well as our exemplary equity stewardship rating. We think HollyFrontier is a solid combination of an undervalued company that is very well positioned in the new U.S. refining environment with some of the best capital allocators in the industry at the helm. HollyFrontier's efforts to return capital to shareholders are impressive, and we think they can continue to return robust amounts of cash to shareholders over the next few years.

	Top Energy Sector Picks
		Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
	Ultra Petroleum		$40.00	Narrow	High	$24.00
	HollyFrontier		$59.00	Narrow	High	$29.50
	Suncor		$52.00	Narrow	Medium	$36.40
	Apache		$110.00	Narrow	Medium	$77.00
	National Oilwell Varco		$85.00	Wide	Medium	$59.50
	Data as of 6-18-13

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.

HollyFrontier  HFC
HollyFrontier rates as one the most attractive independent refiners, in our opinion. Thanks to its advantageously located refineries that serve protected markets with premium margins and an ability to capitalize on the WTI-Brent differential, HollyFrontier has outpaced its rivals despite an overall improvement in industry conditions. While the differential has narrowed of late sending shares lower, we think it will ultimately settle around $10 per barrel, implying Holly's current valuation is attractive. Also, HollyFrontier is well positioned to take advantage of heavy crude discounts thanks to past investment in upgrading capacity and greater availability of discount crude in the region. Holly is also focused on shareholder returns with a 7% yield including ongoing special dividends and a $500 million share repurchase plan.

Suncor Energy  SU
While Suncor production growth to 2017 has been trimmed to reflect delays to the oil sands mining expansion plans, it remains on track to deliver robust growth in liquids production. Over the next five years (2013-17), in situ production is expected to see a 10% compound annual growth rate as expansions at Firebag come on line. Growth from its offshore assets is expected in 2014-15, contributing to an expected 4% production CAGR for the company, offsetting an expected negative 15% CAGR from natural gas. By 2017, we look for total production of 689,000 barrels per day. Despite the growth potential, the market seems overly concerned about cost inflation, in our opinion, and the recent impairment of the Voyageur Upgrader. Although we expect cost inflation to return to the region with the acceleration of development, most of the oil sands players appear ready to avoid the rampant rise in costs that accompanied the last investment cycle. For its part, Suncor has expressed willingness to delay mining projects if necessary (and transfer capital to in situ projects) to avoid higher costs, which may otherwise damage returns. Continued near-term strength is expected from its downstream operations, which are able to sell refined products at global prices, while securing a significant amount of feedstocks at depressed midcontinent prices.

Apache  APA
Apache is one of the largest independent exploration and production companies, and also one of the most unloved. Apache's shares are down 30% over the last year, badly trailing its peer group, thanks to concern over two issues: 1) whether the company's cash flow machine in Egypt will be hurt by ongoing political unrest, and 2) whether management's growth target of 6% to 9% per year can be achieved without acquisitions. Based on our work, which includes a deep dive on the macro situation in Egypt and the company's portfolio in the U.S., we think concerns over these issues are overblown, and that the risk/reward ratio for Apache is as favourable now as it's been in recent memory. Moreover, we think a handful of catalysts could drive the stock north of $100 by the end of next year.

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 near-record $3 billion 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. However, we expect the segment to get back on track later this year and view the 22%-23% range for rig technology margins in the latter stages of 2013 as achievable. 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.

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