MS: Q2 Results - What to expect

[dan_s]

Devin McDermott – Morgan Stanley
July 17, 2018 3:07 PM GMT

The stage is set for E&Ps to deliver attractive FCF and capital returns, supporting continued strength in the group. Oil transport bottlenecks in the Permian will slow US growth, reinforcing a bullish oil backdrop. We add coverage of 12 large-cap and diversified E&Ps. Top picks: COP, OXY, CLR.

Confluence of factors support a sustained rally, launching large-cap & diversified E&P coverage with an Attractive view.

After years of outspending cash flow and disappointing investors, driving ~10,000 basis points of underperformance versus the S&P 500 in 2013-17, North American Exploration & Production companies are finally reaping the benefits of lower supply costs and higher oil prices. Sustainably higher free cash flow and new capex discipline should drive significant return of capital, which we think will extend the recent oil-fueled rally, regardless of whether oil moves higher.

Despite a constructive setup, investor positioning in E&Ps is still near 10-year lows. Against this backdrop, we are expanding our Energy coverage with the addition of 12 large-cap and diversified E&Ps; we have a relative preference for our new diversified large-cap coverage over smaller and more focused single-basin E&Ps.

Numerous dynamics should underpin a sustained rally in the group, with four key insights driving our views:

1. Cash flow inflection supports attractive capital return, even if oil prices plateau. Over the past several years the cost of supply for US E&Ps has fallen, oil prices have risen, and many management compensation plans have changed to emphasize returns over growth. The result: E&P operating cash flow should exceed capex + dividends for the first time in over 10 years, and spending relative to cash flow should fall further in 2019. A sector that has burned $18.5Bn of cash over the past three years should finally turn profitable and generate ~$77Bn over the next three, supporting potentially significant return of capital to shareholders through share buybacks and dividend for the first time in over 10 years, and spending relative to cash flow should fall
further in 2019.

2. Free cash flow drives relative performance in E&P. Working with our Quant team, led by Brian Hayes, we've analyzed factors contributing to E&P outperformance. While historically
absolute growth was rewarded, debt-adjusted free cash flow growth and yield have taken over as the best predictors of stock performance. Production growth per debt adjusted share, which penalizes for outspending cash flow, is also a strong indicator. Improving shale economics have resulted in long inventory runways for E&Ps, and investors are rewarding disciplined investment and return of cash over resource capture.

3. Energy is a consistent late cycle outperformer. Our chief US equity strategist, Mike Wilson, remains bullish on energy in a late cycle environment, which typically includes supply/
demand imbalances brought on by expanding economies that stretch supply chains, benefiting oil prices, the energy sector broadly, and E&Ps.

4. Permian "pause" is bullish for global oil prices, but not all E&Ps will benefit uniformly. As part of a collaborative analysis with our global energy team, also published today, we forecast US 2019 oil production will fall short of expectations by ~30%, as oil transport bottlenecks in the Permian Basin and other areas limit investment. Cushing constraints are also a risk, supporting wider Brent-WTI spreads in 2H18-19. This supports our oil strategist Martijn Rats' bullish call on Brent oil prices. However, not all E&Ps stand to benefit: We expect those exposed to the Permian to see downward pressure on growth and cash flow, while diversified companies with exposure to international price benchmarks should enjoy outsized margin expansion. Our 2019 EBITDA estimates are ~7% above consensus for diversified large-cap E&Ps and ~22% below consensus for Permian-focused names. < This is why I have been focused recently on small-caps with production outside of the Permian Basin. The Eagle Ford companies (LONE, CRZO and SN) are getting a premium to WTI for their oil, especially LONE.

Morgan Stanley's Top Picks (keep in mind that their focus is on large-caps): We favor free cash flow growth and Brent exposure.
Our Overweights have attractive free cash flow with strong debt-adjusted growth and nearly all have exposure to Brent-linked prices, with the potential for increased return of cash to shareholders over the next 1-2 years. Conversely, our Underweights are generally outspending cash flow and have exposure to infrastructure issues, higher risk assets, and/or cost inflation.
Top OW picks: COP, OXY and CLR.
New UWs: APA and MUR.
Downgrading EGN to EW and refreshing our PTs on MID-cap E&Ps