Wall Street Gang now BULLISH on Energy Sector

[dan_s]

Evan Calio – Morgan Stanley
January 16, 2018

As E&Ps deliver on promises of capital discipline, US oil production growth should moderate, supporting higher oil prices and fostering increased M&A.
We are bullish E&P for 3 reasons: 1) improving fundamentals, 2) a strong outlook for oil, and 3) weak sentiment could sharply improve.

Don't wait for a pullback, expect the rally to continue into 2Q for US E&P. We see the potential for US E&Ps to rally another 15-20% into 2Q as (1) the group discounts less downside risk to oil prices and (2) as generalists, who are struggling to find value, warm up to a sector with a bright outlook that has underperformed both oil and the broad markets.

Oil is in better shape than a year ago with inventories having fallen closer to normal levels, while strong demand and curtailed supplies support further strengthening. US E&P fundamentals continue to improve: (1) valuation is more attractive (10x NTM EV/EBITDA a year ago compares to 6.7x/5.4x 2018/19 on spot $65 oil, and a typical range of 5-9x), (2) E&Ps are spending less relative to cash flow (92% in 2018 vs. 118% in 2017), and (3) balance sheets are in good shape and continue to de-lever. More E&Ps are set up well to return cash to shareholders in 2018 and many have expressed a willingness to do so.

Lastly, higher oil prices make asset transactions and corporate deals more appealing. We believe M&A activity could pick up mid-year and sustain the rally past 2Q. Top US E&P picks: EOG, DVN, CLR, XEC.

Energy could become a consensus overweight sector by mid-2018 if fundamentals remain tight. The oil demand outlook is strong and OPEC supply cuts could maintain upward pressure on oil prices and build confidence in a higher baseline for the commodity. If OPEC/Non-OPEC cuts hold (our house view) we believe energy is likely to become a consensus overweight sector by mid-2018 and re-rate the group higher.