By Alex Kimani
- Goldman Sachs: Brent oil prices have reached new highs since October 2018, and we forecast that this rally will continue
- Goldman Sachs analyst Neil Mehta has recommended ConocoPhillips (NYSE:COP) and ExxonMobil (NYSE:XOM) as the best options to play the new gusher in oil prices
- Tudor Pickering rates Chesapeake Energy (NYSE:CHK) a Buy, saying the company remains one of the few producers that remain relatively unhedged
After a volatile period of reversals and re-reversals, the oil price rally is back with a bang as oil prices continue taking out multi-year highs. Bullish sentiment has taken over oil markets, with Brent breaking out above $80 for its best level since October 2018 while WTI was quoted at $75.64/bbl on Tuesday intraday trading, scoring the highest settlement since July thanks to an overall risk-on theme returning to the markets after the Senate passed the crucial $1 trillion infrastructure spending bill.
However, as with every other sector, there’s a pretty big dichotomy in Wall Street regarding the oil price outlook, with both strongly bullish forecasts for even higher highs as well as strongly bearish views predicting a sharp oil price pullback.
The good news: Wall Street remains largely bullish about the oil price trajectory.
Goldman Sachs has become the latest punter to weigh in with a pretty solid bullish thesis.
“Brent oil prices have reached new highs since October 2018, and we forecast that this rally will continue, with our year-end Brent forecast of $90/bbl vs. 80/bbl previously. While we have long held a bullish oil view, the current global oil supply-demand deficit is larger than we expected, with the recovery in global demand from the Delta impact even faster than our above consensus forecast and with global supply remaining short of our consensus forecasts.”
GS further notes that, “Hurricane Ida has more than offset the ramp-up in production by OPEC+ since July with non-OPEC+ non-shale production continuing to disappoint. Available vaccines have so far proven effective against the Delta variant leading to lower hospitalization rates and allowing more countries to re-open particularly in Covid-averse countries in Asia. Meanwhile, winter demand remains skewed to the upside with a global natural gas shortage continuing to bite. Goldman has predicted that the latest inventory draw of 4.5mb/d–the largest on record–is unlikely to be reversed in the coming months and sets the stage for oil inventories to drop to their lowest since 2013.”
GS is not the only strong oil bull here.
Back in June, a Bank of America analyst made waves after predicting that oil prices could be headed to $100.
BofA commodities strategist Francisco Blanch said he sees a case for $100 a barrel oil in 2022 as the world begins facing a serious oil supply crunch:
“First, there is plenty of pent up mobility demand after an 18 month lockdown. Second, mass transit will lag, boosting private car usage for a prolonged period of time. Third, pre-pandemic studies show more remote work could result in more miles driven, as work-from-home turns into work-from-car. On the supply side, we expect government policy pressure in the U.S. and around the world to curb capex over coming quarters to meet Paris goals. Secondly, investors have become more vocal against energy sector spending for both financial and ESG reasons. Third, judicial pressures are rising to limit carbon dioxide emissions. In short, demand is poised to bounce back and supply may not fully keep up, placing OPEC in control of the oil market in 2022,” explained Blanch.
Meanwhile, UBS maintains a pro-cyclical bias, expecting rates to climb further. With a strong tilt to recovery, UBS says it favors Energy (NYSEARCA:XLE), Consumer Discretionary (NYSEARCA:XLY), Financials (NYSEARCA:XLF), and Industrials (NYSEARCA:XLI).
“Overall, our outlook for growth in the economy and corporate profits remains unchanged and our fixed income team expects interest rates to reverse course and for the 10-year Treasury yield to rise toward 2% by the end of the year. We therefore view the recent underperformance of cyclical segments as temporary.”
How to Play the Oil Price Rally
At this juncture, it’s safe to say that Wall Street is decidedly bullish on the oil price outlook.
Goldman Sachs analyst Neil Mehta has recommended ConocoPhillips (NYSE:COP) and ExxonMobil (NYSE:XOM) as the best options to play the new gusher in oil prices.
“The company should deliver 30%-40% of cash flow back to shareholders in the form of dividends/buybacks, has proven a core competency around M&A execution, offers a better geographic diversification than many E&Ps [exploration and production companies], but higher oil leverage than the U.S. majors. In addition, the stock trades at the highest free cash flow yield among the majors in 2022 and lowest EV/DACF multiple,” Mehta contends.
“Exxon is one of our most out of consensus ratings, where most investors we speak to are concerned about (a) the sustainability of earnings execution given weaker EPS surprise ratios than the S&P in recent years and (b) the premium valuation versus U.S. oil peers. However, we argue a premium valuation is justified by a strong asset base and historical trading patterns. We also see earnings beats continuing well into the future.”
In the year-to-date, COP and XOM shares are up 66.8% and 43.9%, respectively.
Natural gas mega rally
Let’s now delve into the biggest highlight of this energy bull: The natural gas mega rally.
Natural gas prices have hit their highest levels since 2014, outpacing oil and many other commodities. On Tuesday, natural gas futures were trading up 5.2% to $6.13 per million British thermal units (BTUs), their highest settlement price since January 2014. Natural gas prices are up 125% in the year-to-date, while the biggest nat. gas benchmark, the United States Natural Gas ETF, LP (NYSEARCA:UNG) is up 121% over the timeframe. The sticker shock is even greater in other key natural gas markets around the globe, with East Asian benchmark futures and European natural gas spot prices have climbed 4-5 times year-ago levels to $19 per MMBtu.
Natural Gas (Henry Hub) USD/MMBTU
Yet, some experts are saying that this rally is far from over.
Stan Brownell, an analyst at Argus Media, and Luke Jackson, an analyst at S&P Global Platts, figure that Henry Hub prices would have to jump to $10 or more to provide an incentive to fulfill domestic natural gas demand.
That would mean nearly doubling of natural gas prices from current levels to levels last seen in 2008 when the U.S. produced about 40% less natural gas.
International natural gas demand is booming.
An unusually cold winter in Europe as well as a global rebound from Covid-19 have triggered strong demand and depleted natural gas inventories. Meanwhile, Hurricane Ida has knocked out a considerable amount of gas production, with 77% of oil and gas production still offline in the Gulf of Mexico. According to U.S. government statistics, natural gas inventories are currently 17% lower compared to a year ago and 7.4% below the five-year average.
To catch up to the five-year average storage level by early winter, U.S. natural gas producers need to inject roughly 90.4 billion cubic feet each week from now, about 40% higher than the five-year average weekly buildup clip. The latest data by the Energy Information Administration shows that nat. Gas inventories climbed 52 bcf last week, way below what is required to build enough stockpiles for the winter.
Interestingly, the analysts note that U.S. consumption isn’t really the driving force behind the strong price action. Indeed, according to data from the U.S. Energy Information Administration, domestic natural-gas consumption through June was in line with 2020 levels.
The real culprit here is robust international demand for natural gas as well as a fast-growing U.S. LNG sector.
In the first half of the year, the U.S. exported roughly 10% of its natural gas, or 41% more than a year ago. Normally, excess natural gas produced during the summer would go into underground storage. But that domestic stockpiling has been lower than normal, with producers exporting much of it as LNG.
Asia and Europe still need to stock up more to prepare for the winter, and much of their supplies will have to come from the U.S. because non-U.S. LNG exporters have mostly been down with maintenance-related snags. For instance, Russia, Europe’s most important natural-gas provider, has been slowing its deliveries. Natural gas inventories in Europe are currently a whopping 16% below the five-year average and at a record low for September. Meanwhile, continuous unplanned outages at LNG export facilities in several countries, including Australia, Malaysia, Nigeria, Algeria, Norway, and Trinidad and Tobago, have contributed to increased demand for U.S. LNG.
Europe’s natural gas spot prices have historically been lower than prices in Asia; however, this year, Europe’s natural gas prices are tracking Asia’s spot LNG prices more closely to attract flexible LNG supplies from around the world to refill storage inventories.
A severe winter in the U.S. could lead to domestic markets having to compete with hungry Asian and European buyers, thus driving prices even higher.
A severe winter in the U.S. could easily lead to an even crazier surge in natural gas prices.
How to Play the Natural Gas Rally
Commodity price hedging is a popular trading strategy frequently used by oil and gas producers as well as heavy consumers of energy commodities such as airlines to protect themselves against market fluctuations. During times of falling crude prices, oil and gas producers normally use a short hedge to lock in oil prices if they believe prices are likely to go even lower in the future. According to Tudor Pickering Holt & Co via Barron’s, the majority of the energy companies they cover have hedged away significant portions of fourth-quarter cash flow (about 85% hedged on average in the US).
Unfortunately, hedging also means that these companies are unable to enjoy the benefits of rising gas prices and can, in fact, lead to hedging losses.
However, some bold producers betting on a commodity rally hedge only minimally or not at all.
Tudor Pickering rates Chesapeake Energy (NYSE:CHK) a Buy, saying the company remains one of the few producers that remain relatively unhedged.
This might come off as an odd pick given Chesapeake’s history, but it somehow makes sense at this point.
Widely regarded as a fracking pioneer and the king of unconventional drilling, Chesapeake Energy has been in dire straits after taking on too much debt and expanding too aggressively. For years, Chesapeake borrowed heavily to finance an aggressive expansion of its shale projects. The company only managed to survive through rounds of asset sales (which management is averse to), debt restructuring, and M&A but could not prevent the inevitable–Chesapeake filed for Chapter 11 in January 2020, becoming the largest U.S. oil and gas producer to seek bankruptcy protection in recent years.
Thankfully, Chesapeake successfully emerged from bankruptcy this year with the ongoing commodity rally offering the company a major lifeline.
The new Chesapeake Energy has a strong balance sheet with low leverage and a much more disciplined CAPEX strategy.
The company is targeting <1x long-term leverage in a bid to preserve balance sheet strength, target production is 400+ thousand barrels / day and intends to limit CAPEX to $700-750 million of annual capital expenditures and positive FCF. CHK says it expects to generate >$2 billion of FCF over the next 5 years, enough to improve its financial position significantly.
CHK shares are up 40% since its March comeback.
#2. Cimarex Energy
Meanwhile, Mizuho has picked Cimarex Energy (NYSE:XEC) as another stock to play the natural gas boom.
Mizuho has upgraded XEC to Buy from Neutral with a $95 price target, citing the company’s “now-attractive free cash yield” following the recent weakness and payout capacity of its merger with Cabot Oil & Gas (NYSE:COG).
Mizuho says the combined entity trades at an attractive value compared to oil peers and at “just a small premium” vs. gas peers following weakness since the merger announcement.
“Balance sheets have improved significantly YTD, positioning the group for attractive cash return not only at $65/bbl but through the cycle, and we remain very constructive for that reason, with average upside 46% in our oil coverage,” Mizuho’s Vincent Lovaglio writes.
Natural gas already makes up the majority of Cimarex’s production which should climb even further after its merger with Cabot, another primary natural gas producer.