After a tumultuous year for the energy sector in 2015, S&P Capital IQ Equity Research expects 2016 to bring additional surprises. Here are six predictions for this closely-watched sector in the new year.
Crude oil spends 2016 range-bound. S&P Capital IQ Equity Research thinks a range of $30/barrel to $50/barrel for WTI crude oil seems reasonable on fundamentals. On the downside, risk of a slowing China could weigh on global gross domestic product (GDP), adversely affecting demand. On the upside, we don't think geopolitical risks are adequately factored into commodity prices, the impact of flashpoints around the globe currently muted by high supply levels. We think non-OPEC production growth (year over year) finally rolls into negative territory sometime in 2016, but not quickly enough for most producers' liking. As of late December 2015, Bentek Energy, a unit of Platts, forecast WTI averaging $46/barrel in 2016. This represents a slight decline from the 2015 average of $49/barrel. Upside risks to this thesis include a major supply shock and a depreciating U.S. dollar.
Energy sector stock performance should be less terrible in 2016. The sector has lagged the S&P 500 regularly in recent years, and the relative performance has not been close. In 2015, the energy sector returned -24.4%, far worse than the '500's -1.0%. In 2014, energy's relative performance was similarly poor - a return of -11.3% versus the '500's +10.9%. In both years, energy performed worse by more than 2,000 basis points. Jodie Gunzberg of S&P Dow Jones Indices pointed out recently that energy stock price correlations to crude oil prices have been on the rise of late, to the 0.45-0.50 range, about double prior levels in the 0.25 range. If crude oil prices are able to hover in the vicinity of $46 per barrel (see above), which implies a modest, single-digit decline on a percentage basis, S&P Capital IQ Equity Research thinks energy performance will manage to track more closely to the S&P500's performance this time around.
U.S. shale was the catalyst to get us into this mess, and it will also get us out. Until October 2014, the last major supply-driven energy downturn was in the mid-1980s and the industry experienced four straight years of upstream capital spending declines. Of course, in the mid-80s, decline rates (the rate at which a producing well will generate lower production year after year) was in the low single digits. U.S. shale, however, is a completely different animal - decline rates of 60% in year 1 and perhaps 40% in year 2 are not at all uncommon. Aggregate levels of upstream capital spending in 2015 won't be fully known for several weeks, but Capital IQ consensus estimates point to a more than 30% cut to capex in 2015, and a further 17% decline in 2016. We think 2016 is the last year of capital spending cuts before a recovery in 2017. Borrowing from Thomas Hobbes, this downturn may turn out to be nasty, brutish and short.
Energy midstream looks potentially rocky, depending on whether capital markets cooperate or not. The emphasis on distribution coverage ratio ignores the role in capital markets in furnishing the midstream space with much-needed capital to finance their expansion plans. Should capital markets look askance at midstream, in light of stubbornly weak crude oil prices, we think this model comes under pressure. Analyzing the combination of dividend payments plus growth capital projections, and comparing those to expected cash from operations, we see an industry that could struggle in 2016, particularly at Enbridge Energy Partners LP (EEP 23 *), NuStar Energy LP (NS 40 **) and Sunoco Logistics Partners LP (SXL 25 ***). Kinder Morgan Inc. (KMI 24 ****) already slashed its dividend by 75% and we do not think it will be the last.
The lifting of the U.S. oil export ban may ultimately be much ado about nothing. Timing is everything! A few years ago, when WTI traded at a more than $20 per barrel discount to Brent crude oil, owing tologistics problems in the U.S., the ability to ship some of that crude oil overseas might have been tantalizing. Today, the Brent-WTI spread has collapsed to a mere $0.10 (yes, 10 cents), so when one factors in the cost of crude oil transport (no longer cheap because of rising demand for floating storage that has absorbed formerly idle crude oil tankers), the value proposition of U.S. crude is less attractive. There may be some cases where U.S. light-sweet crude oil is attractive in overseas markets due to crude quality, but we do not see the lifting of the export ban as a blanket panacea for a challenged industry.
Among producers, efficiency matters more than growth now. This is good news for well-managed upstream companies in our view, especially those likely to generate positive free cash flow, such as ExxonMobil (XOM 77 ****) or Occidental Petroleum (OXY 66 ****). Overall, among our S&P STARS universe, and using Capital IQ consensus estimates, we see the median company generating 2016 cash from operations that amounts to just 86% of capital spending; XOM (124%) and OXY (129%) compare very favorably on that front and should have latitude to pursue strategic plans, such as potential asset acquisitions.
Note: S&P Capital IQ Equity Research operates independently from S&P Dow Jones Indices.
All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Copyright©2016. For important regulatory information, please go to www.capitaliq.com/home/legal-disclaimers.aspx