Note from Wells Fargo Equity Research Team

[dan_s]

U.S. E&P Stocks seem to be front running lower oil price expectations

A long standing view of energy investors has been that U.S. E&P stock returns tend to be highly correlated
with commodity prices – particularly oil prices. This relationship appears to be breaking down in 2019,
with the XOP underperforming the 12-month WTI strip by ~28% YTD. As shown below, even though the
12-month market outlook for WTI prices has improved since January by ~6.5%, the XOP continues to
make new multi-year lows – in fact it is currently ~10% below its prior low established in December 2015.

More recently, even as renewed fears of a global economic slow-down have weighed on commodity (oil)
prices, the 12-month Nymex WTI futures strip still stands at ~52/bbl. However, the XOP is ~24% and
~32% below where it was the last two times the 12-month futures strip was at this level (June 2019 and
December 2018, respectively).

As we have highlighted in our recent note, despite a tumultuous 2Q19 earnings season, shale operators
continue to transition towards a business model that prioritizes generating free cash flows and returning
that cash to shareholders above volume growth (Shale 2.0/3.0). This should ultimately be a more
sustainable and valuable business model for U.S. shale operators. While investor skepticism is justified
(particularly since the sector is yet to deliver a quarter of aggregate FCF), many high quality operators
have active buyback programs to support their stock valuations but are still losing market cap by the day!

As shown below, we expect our coverage of 29 U.S. E&P stocks to deliver ~$1.9 billion of FCF (post
dividends) in 4Q19e, despite assuming a $53/bbl WTI price that is ~3% below the current Nymex futures
strip. Furthermore, we estimate that WTI prices in 4Q19 would need to drop to ~$45/bbl – or ~17%
below current Nymex strip levels for our coverage to not generate free cash flows in 4Q19e and F2020e.

In our opinion, not only are investors disbelieving the FCF story being told by U.S. E&P management
teams, they are also already incorporating the expectation of lower oil prices over the next 12 months into
their valuation of U.S. E&P stocks. In fact, after updating our models post 2Q19 earnings, we estimate
that stocks are pricing in a long term WTI price of ~$45/bbl - ~12% below the F2022e Nymex WTI
outlook of ~$52/bbl.
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MY TAKE: If WTI stays in the mid-$50s we will see U.S. oil production stop growing (probably already happening) and may see a steady decline in U.S. oil production. Why? because upstream companies will slash drilling budgets to just do minimal development drilling. The last sentence of the post above is true. Q3 average WTI oil price will probably end up close to the average oil price in Q1. The companies in our Sweet 16 and Small-Cap Growth Portfolios reported decent results in Q1.

[dan_s]

Wells Fargo Equity Research Team recently reordered their top E&P picks.
Below are Wells Fargo's favorites that I cover. They had a total of 16 companies ranked as Outperform. 9 of them are in our Sweet 16 or Small-Cap Growth Portfolios.

Wells Fargo's New Price Target
$171 for FANG < WF's #1 pick
$33 for PE < WFs #2 pick
$190 for PXD < WF #4 pick
$50 for PDCE
$9 for SCRI
$14 for JAG < I am going to drop JAG from our Small-Cap Growth Portfolio because they will struggle until ngas and NGL prices rebound in the Delaware Basin.
$105 for CXO
$53 for CLR
$103 for EOG

Wells Fargo rates these as "Market Preform": ESTE, XEC, MTDR, SM, OAS, CDEV, GPOR and AR , but their price targets are well above the current share prices for all of them.