The Street Is Overlooking Natural Gases Tendency To Self-Correct And The Positive Efects Of New EPA Rulings, Says Head Of Oil And Gas Equity Research At Societe Generale
January 19, 2012 - The Wall Street Transcript has just published Oil & Gas: Refining, Independent and Major Integrated Report offering a timely review of the sector. This Special Report contains expert industry commentary through in-depth interviews with public company CEOs, Equity Analysts and Money Managers. Please find an excerpt below.
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John P. Herrlin Jr. was hired by Societe Generale Corporate & Investment Banking to head its oil and gas equity research in the U.S., where he will cover U.S. integrated energy companies as well as North American independents (E&Ps). He will be based in New York. With the launch of its U.S. equity research coverage of the oil and gas industry, Societe Generale Corporate & Investment Banking now offers its global investor clients a full complement of first-rate energy research, ranging from the bank's leading European energy company coverage as well as Societe Generale Corporate & Investment Banking's oil commodity research which was ranked number one by Risk magazine in 2009. Mr. Herrlin has an undergraduate degree in geology from The University of Montana, conducted graduate studies in geology from the University of Montana and Colorado School of Mines, and he earned an MBA in finance and energy management from the University of Denver.
TWST: In your reports, you have written that the energy subsectors went from being a place to be to being a place to avoid, and then you said that the shift is actually a positive thing. Would you please elaborate on that?
Mr. Herrlin: That comment refers to relative index weight, the degree to which it can change over time, and the effects of market crowding. Having been on the Street for two decades, I've probably spent over half of my career where investors didn't care a lick about the energy sector. Only in the last five to seven years has it become more of a go-to sector, and the bias has switched more to beta rather than index names. If you look at the energy weight of the S&P 500, it's about 11.5% now. In 1982, energy stocks were 32% for a day, but by 1999, they were 5.7%.From a valuation perspective, these stocks trade at multiples of cash flow or earnings in the case of the IOCs which are below other industry groups. Further, most of these companies have balance sheets with less fiscal leverage than the average company in the S&P 500. Thematically, investors focus more on this sector during times of supply or geopolitical uncertainties, or on smaller companies in the belief in M&A. Over the last couple of years, many investors hopped on board because they believed that U.S. natural gas supply/demand balance would tighten or that oil prices would rise. In a sense, these stocks have begun to trade more as macro thematic risk proxies for global markets rather than on company specifics. Today, I think everybody understands the non-OECD oil demand growth story given rising per capita. That said, many investors appear to have a shorter investment time horizon than in the past. If one looks at how the stocks traded in 2011, the larger or more defensive E&Ps and IOCs outperformed their smaller-cap brethren, but short-term pricing volatility was high. By September, given all of the global economic concerns, many had thrown in the towel and liquidated. I got more aggressive in October and probably have the most stocks "buy" rated now than I've had in my career.
TWST: In one of your reports, you broke down and divided the sector into the different subsectors: on/offshore drillers equipments side, engineering and construction, etc. Of each of those sides of the sector, which is best way to play the sector?
Mr. Herrlin: I only follow the E&Ps and the integrateds, IOCs. The other ones I frequently reference in terms of performance, cap size or valuation are the oilfield service and equipment companies - followed by Ed Muztafago at Societe Generale - contract drillers and independent refiners. Given overall stock market volatility, the bigger companies, especially the large cap IOCs like XOM and CVX, will tend to have less relative up and downs than E&Ps. In the case of the large IOCs, they are companies with hundreds of billions in market cap that are either net debt negative or have very low fiscal leverage. They tend to be treated by investors as defensive portfolio constituents. At the time of this interview, most of the integrateds were down in line with the market at 2%, but the E&Ps were down 4% to 5%. Given current economic uncertainties, I believe that the IOCs will have differential performance. The E&Ps will remain volatile. Going forward, assuming that 2012 has a continuation of relatively high oil prices - we're using $90 a barrel WTI in our models, assuming $4 gas, weak in the fist half and strong in the second - the E&P stocks and IOCs themselves are not, in our opinion, expensive. But few portfolio managers are establishing new energy positions right now, and at the margin, hedge funds are trading until year end, but we don't view that to be trend-setting activity. From a subsector perspective, traditionally, the oilfield services and contract drilling stocks were the first differential on spending, and the E&Ps and IOCs followed. That relationship has changed. Now, E&P stocks have become more of the spending proxies given all of these shale plays, and then the IOCs. Even though E&D, exploration and development, spending is up, oilfield services stocks have, on average, lagged our coverage universe.
TWST: When you look to the midterm and the long term, what are the geographic areas you think would be most promising for oil and gas exploration and production? Which of the companies that you cover do you think are best positioned to take advantage of any kind of emerging opportunities?
Mr. Herrlin: In terms of differential volume growth, conventionally, it's going to either be situated in foreign locales that have access or economic conversion issues such as the Arctic or Deep H2O, deepwater, which is a large report which was recently published that I submitted to you. In the Americas, it's obviously going to be the onshore shale plays, or again deepwater, which is reawakening post its Macondo activity hiatus. The typical E&P produces 56% natural gas, with a high as much as 99%. The average integrated produces 60% oil. Geographically, the typical E&P company has 90% or more of its output located in North America. For the IOCs, North American production may only be 40% to 50% of global equivalent output. Since each company is unique in terms of its producing assets, one needs, from an investment perspective, to focus on a company's longer term spending trends from geographic, physiographic and risk-based histories. For example, did a company get bigger because it sought high risk wildcatting and was successful, did it make acquisitions of proven producing properties or acreage where it ramped up development drilling activity? And how have the bottom line results been? Has there been good ROCE or free cash flow generation? I find, especially in the case of E&P stocks, that investors buy the growth stories but don't look that closely at fiscal metrics because they are making M&A suppositions. So in our opinion, in 2012 we expect oil-levered entities to remain differential, and those companies with successful exploration programs versus natural-gas-leveraged, exploitation-oriented E&Ps such as ECA. We don't expect natural gas prices to recover until the second half of the year given the poor start to winter and ample supplies. We do expect the industry to reduce U.S. natural gas capex meaningfully, and note that versus the start of 2011, we don't have Haynesville equivalent wells inventoried in need of fracking. Also, given the industry's liquids focus, we won't experience the same type of natural gas output growth. Frankly, we find most on the Street to be very negative on natural gas. They're overlooking the commodity's tendency to self-correct or positive effects of new EPA rulings which could displace more coal-fired power.
TWST: As we look forward to 2012, what are your predictions about trends or themes we might see emerge in the oil and gas sector?
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