Energy Sector Update from Well Fargo dated 10/13/19
Posted: Fri Oct 18, 2019 12:28 pm
Comments below are from the Wells Fargo Equity Research Team.
Upstream Oil & Gas Stocks look cheap, but is this the time to buy?
The underperformance of the sector in 2019 has been dramatic, particularly as the operations themselves are doing well. On many traditional metrics used to evaluate the sector - NAV, EV/EBITDA – the sector looks incredibly cheap. For instance, the average implied upside to NAV for our coverage is ~75%, and based on consensus 2020 estimates, the sector is trading ~4.5x – or ~1.6 standard deviations below the 5 year average. A telling metric is the long term price implied by our coverage - ~$47.56/bbl is nearly 6% below the 2 year Nymex strip – ergo the valuation discount is not simply a function of price targets based on above - Nymex Commodity Price Outlook.
However, we think investors who have mostly given up on the U.S. E&P sector are not going to be wooed back by just discounted valuations – at least not yet. E&Ps need to demonstrate that they can generate free cash flows at lower commodity prices and are committed to giving that cash back to investors via a dividend or a share buyback, even if that means lower capital activity. We call this “Shale 3.0” – a concept that we discussed in our July 8 note (Beyond Shale 2.0, Flatter for Longer).
As discussed later in this report,we estimate that U.S. E&Ps will once again fall short of delivering free cash flow on aggregate in 3Q19 as commodity prices were lower and capex ran ~4% above consensus.
While most operators initiated capital return plans at or just after 2Q19 earnings, the market does not seem to believe they can do so and failing to generate free cash flow in a quarter when oil prices average $56/bbl – or 10% above 2 year strip is not confidence inspiring. To be fair, 2019 was a transitional year for many E&Ps and we can see the ground swell of change – which supports our Overweight view on the sector. But investors are tired of excuses, and we suspect wanting to see upward momentum rather than bottom fishing for “value”.
Upstream Oil & Gas Stocks look cheap, but is this the time to buy?
The underperformance of the sector in 2019 has been dramatic, particularly as the operations themselves are doing well. On many traditional metrics used to evaluate the sector - NAV, EV/EBITDA – the sector looks incredibly cheap. For instance, the average implied upside to NAV for our coverage is ~75%, and based on consensus 2020 estimates, the sector is trading ~4.5x – or ~1.6 standard deviations below the 5 year average. A telling metric is the long term price implied by our coverage - ~$47.56/bbl is nearly 6% below the 2 year Nymex strip – ergo the valuation discount is not simply a function of price targets based on above - Nymex Commodity Price Outlook.
However, we think investors who have mostly given up on the U.S. E&P sector are not going to be wooed back by just discounted valuations – at least not yet. E&Ps need to demonstrate that they can generate free cash flows at lower commodity prices and are committed to giving that cash back to investors via a dividend or a share buyback, even if that means lower capital activity. We call this “Shale 3.0” – a concept that we discussed in our July 8 note (Beyond Shale 2.0, Flatter for Longer).
As discussed later in this report,we estimate that U.S. E&Ps will once again fall short of delivering free cash flow on aggregate in 3Q19 as commodity prices were lower and capex ran ~4% above consensus.
While most operators initiated capital return plans at or just after 2Q19 earnings, the market does not seem to believe they can do so and failing to generate free cash flow in a quarter when oil prices average $56/bbl – or 10% above 2 year strip is not confidence inspiring. To be fair, 2019 was a transitional year for many E&Ps and we can see the ground swell of change – which supports our Overweight view on the sector. But investors are tired of excuses, and we suspect wanting to see upward momentum rather than bottom fishing for “value”.