Q3 Review: Can Energy Industry Stocks Rally On $50 Oil?

Q3 Review: Can Energy Industry Stocks Rally On $50 Oil?

A monthlong rally lifted the price of U.S. benchmark oil during the past week to a 28-month high, cranking up attention on third-quarter reports from exploration and production names.

[ibd-display-video id=2368044 width=50 float=left autostart=true]Domestic energy players have weathered a global, two-year industry glut by tightening belts, cutting costs and adopting novel technological advances aimed at increasing production and lowering break-even costs.

But that glut is now giving way to discussions of pruned oil supplies coming into balance with recovering energy demand. Those discussions received some support as oil prices were spurred higher by news of the Organization of Petroleum Exporting Countries seeking to extend its production limits, and as unrest in Iraq and political drama in Saudi Arabia raised uncertainty in the oil supply chain. As a result, prices broke long-term resistance near the $55-per-barrel level and rose above $57 for the first time since July 2015.

That put prices 36% above a June low on Friday, encouraging analysts to began pointing to a new technical resistance level around $59. The upshift sent stocks in oil and gas-related groups to five of the week’s 15 largest gains, through Friday morning, among the 197 industries tracked by IBD .

IBD’S TAKE: IBD’s U.S. Exploration & Production, Drilling and International E&P groups were among the 10 fastest rising industries over the past four weeks, suggesting they might be a good place to search for leadership-grade stocks .

While many oil-related stocks continue climbing out of long, deep corrections, a select few E&P names, including Concho Resources ( CXO ), Diamondback Energy ( FANG ) and Matador Resources ( MDR ) at least briefly cleared buy points and took new highs during the week. Others, such as Rice Energy ( RICE ) and Anadarko Petroleum ( APC ), either remain in bases or continue recovering from recent lows.

A Disciplined Increase In Spending

One thing clear so far in the current quarter’s reporting season: rather than increasing their production or spending in order to chase rising oil prices, U.S. producers remain focused on proving their conservative financial savvy.

During the oil boom that ran to June, 2014, shale companies had been operating much like Tesla (TSLA), said James Williams, an economist at energy consultant WTRG. When the bottom dropped out of the market, investment money continued flowing into the electric car company, while the same as not true for many U.S. oil names.

“With startups you’re spending a lot more money than you’re making – for a while. Now people are less convinced (that an) investment in an oil company is going to be profitable … they are much more concerned about cash flow” Williams said. “Since less investment money is coming into the industry, you have to fund more of your drilling out of cash flow.”

Williams said this cycle of shifting from a production focus to a cash focus is pretty typical within energy industry cycles. It was possibly amplified somewhat in the current cycle, because the shale revolution started with a rush for leases and, under U.S. law, drilling companies only have three to five years to drill on newly leased land or the lease reverts to the person who owns the mineral rights, Williams explained.

Exploration and production companies scrambled to amass leases and hire rigs during the boom and there were plenty of banks willing to loan them money. But investment funding is now getting harder to come by, Williams said.

So many U.S. E&P companies notched up spending or guidance in their Q3 reports, but also emphasized discipline and their ability to operate within cash flow.

“If you improve your cash flow you look more attractive to investors, even if they are a little uncertain about oil prices,” Williams said.

EOG Resources (EOG), which some analysts have called ‘the Apple of oil’ due to its technological focus, said in its Q3 report that it’s targeting 20% U.S. crude production growth and expects to fund capital expenditures and its dividend with discretionary cash flow. EOG reported its 2017 capital expenditures through Sept. 30 at $545 million, up 45% vs. the same period in 2016.

Anadarko Petroleum ( APC ) CEO Al Walker said in the company’s earnings release that Anadarko remains “focused on returns by continuing to allocate upstream capital toward the higher-margin assets in our portfolio, which should generate substantial free cash flow in a $50 oil-price environment.”

Anadarko forecast its 2017 capital spending at between $5 billion and $5.25 billion, up more than 50% at the low end vs. 2016 spending, but still far below the company’s peak of $9.26 billion in 2014.

Devon Energy (DVN) narrowed its exploration and production capital spending guidance to range from $2 billion-$2.1 billion in 2017 from a prior outlook of $1.9 billion-$2.2 billion. Total capital expenditures were $2.2 billion at the end of Q3, vs. $2.3 billion across all of 2016. The company had spent $6.99 billion in 2014.

Diamondback ( FANG ) narrowed its full-year capital spending outlook to $850 million-$900 million from $800 million-$950 million. At the low end of guidance, that would mark a 28% decrease from spending of $1.18 billion in 2016.

“In an industry that often rewards ‘growth for growth’s sake’, Diamondback has maintained strict capital discipline, growing production over 175% within operating cash flow over the past 11 quarters,” Chief Executive Travis Stice said in the release.

Phil Flynn, a senior market analyst at the Price Futures Group, said he isn’t expecting to see more meaningful capital spending increases until the end of 2018 at the earliest.

Anything Above $55 Oil Is “Kinda Gravy”

Even as they keep a tight rein, U.S. firms are looking at newer land assets to help in the competition to produce more oil at lower costs. EOG announced new premium wells in the Delaware Basin’s First Bone Spring play in New Mexico, and the Woodford oil window in Oklahoma’s SCOOP play.

Devon Energy (DVN) was also active in the Bone Spring play during Q3, and Concho Resources ( CXO ) has acreage there too. Continental Resources (CLR) has Woodford shale assets as well.

But Williams said not to expect companies to spend a lot of money searching for and developing newer plays right now.

“The focus now is profitable development of the fields you already have.”

Parsley Energy (PE) said it plans to focus on “relatively established areas, formations, and configurations” for drilling and completion in 2018. Even so, the company said half the wells drilled and completed the past four quarters were in new counties.

The conservative stance among the companies has not affected the role of U.S. shale production as the world’s swing-production region.

In its World Oil Outlook report last week, OPEC said it expects U.S. shale output to grow faster than previously expected due to increased efficiency among shale producers. The cartel now expects North American shale production to hit 7.5 million barrels per day in 2021, up 56% from its prior outlook a year ago.

U.S. shale companies “have changed their approach to survive and thrive in the $50 oil world. Who would have thought that? Anything above $55-$60 is kinda gravy in a sense,” said Brian Youngberg, an energy analyst at Edward Jones.

Oil Is Volatile, But Still Outplays Gas

Larger, integrated oil firms also followed the cautious capital discipline trend in Q3.  Chevron now sees 2017 capital investments totaling less than $19 billion, below an earlier projection of $19.8 billion, which is down from $22.4 billion in 2016 and $34 billion in 2015. Management said spending is now down by more than half from where it was three years ago, before crude prices collapsed.

But Exxon Mobil (XOM) sees capital spending “in the general ballpark” of $25 billion. That’s up from this year’s earlier projected investment of $22 billion, which was a 14% increase from 2016.

Oilfield service providers – a key recipient of capex dollars spent by oil producers – have an even more guarded take on the oil and gas industry’s spending. In its third-quarter report, Baker Hughes (BHGE) said the overall oil and gas environment will remain challenged for the rest of the year.

“We have seen some improvement in activity, but we have not seen meaningful increases in customer capital commitments,” CEO Lorenzo Simonelli said in an earnings statement. “Oil prices remain volatile and, as a result, our customers remain cautious.”

Baker Hughes fell short of Wall Street exceptions with its Q3 results, its first report since merging into General Electric ‘s (GE) oil and gas business in early July.

But among the service sector’s other leading players, Schlumberger (SLB) saw big gains in Q3 and Halliburton (HAL) beat on strong pricing trends in the U.S.

And despite the challenged environment, oil still stands above natural gas as the more profitable energy play.

“Oil is still the best place for producers to focus on and it’s more profitable now at $50 to $55 per barrel,”  Youngberg said. “Natgas prices are stubbornly at $3 or below and it’s hard to see it moving up much, unless we have a harsh winter.”


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