Stifel's Upstream Oil & Gas Sector Update - Oct 22

[dan_s]

Executive Summary:
In preparation for the upcoming Q320 earnings season, we are updating our commodity estimates to reflect strip prices through 2022, maintaining our long-term WTI and HH price assumptions of $55.00/bbl and $2.75/mcf, and revising our production and capital forecasts to reflect recent discussions with management.
In short, we are adjusting 2020/2021 estimates for rig count (0.2%/-1.9%), capex (-2.4%/-1.0%), and EBITDAX (-10.9 %/-5.7%) and decreasing our 12-month price targets (17.0%). We are also outlining the most impactful themes and catalysts for the sector and coverage universe. For Q320 earnings, we believe investors are keenly focused on 2021 E&P capital and operational plans (assessing financial and operational durability), management views on the M&A environment, management plans to address upcoming debt maturity walls and RBL redeterminations, and the operating/regulatory environment under a Biden presidency. Lastly, we are adding DVN to our Select List (replacing CXO).

Key Points
Energy sector is picking up momentum on the heels of recent M&A and upcoming election.

> Over the last month, we held meetings and calls with ~40 investors. The investor base was comprised of dedicated mutual funds (~25%), generalist (~50%)
and dedicated hedge funds (~25%). Throughout this period, investor interest in the sector has been noticeably higher with a focus on quality stocks to own
for leverage to improving macro and industry fundamentals (reinvestment frameworks and M&A).

> Regarding quality stocks, we have received considerable inbound interest from generalists for large-cap E&P investment ideas. In short, investors are
becoming increasingly aware of the supply impact the emerging U.S. investment framework (maximum reinvestment of 70-80% of cash flow for the U.S.
sector) will have on oil and gas volumes and see that development as a catalyst for higher commodity and stock prices. In addition, investors are mindful
of the sector’s broad underperformance and its strengthening value proposition (versus other industries) that could further improve based on
evolving market conditions (shift from tech-heavy momentum stocks to value stocks, supported by a weak dollar). The stocks of interests include the Majors
(CVX, XOM), large-cap oily E&Ps (COP, EOG, FANG, PXD) and Minerals stocks (BSM, MNRL, TPL).

> While recent transactions (COP-CXO, CVX-NBL, DVN-WPX, PXD-PE) have not contemplated premiums that would justify M&A as a stock-specific
investment strategy, they have created surviving entities with enhanced business models and value propositions. In light of the terminal risk with oil demand
beyond 2030, we believe a new business model is required for companies to elevate their investment proposition. In short, we believe an Upstream business
model should: i) be self-sustaining at prices lower than $40/bbl WTI, ii) generate enough free cash flow to return 100% of a company's enterprise value within
10 years, and iii) offer a path to attain zero emissions from direct operations. We believe the recent transactions accomplish these measures and place
greater pressures on management teams with non-conforming business models to consolidate to lower their cost structures and improve their environmental
performance. We have no knowledge of any M&A negotiations or discussions, however, in our view, this places a premium on the best remaining candidates
for top-down M&A (DVN, PXD, XEC). XEC is perhaps the best remaining target based on its FCF profile and clean capital structure.

> Regarding election risks, we continue to expect Biden to outline a more moderate tone (i.e., no frack ban) towards the Energy sector as his campaign
understands the importance of oil and gas in the battleground state of Pennsylvania. While we agree the potential risks towards the sector could be severe
(as noted in our “Election risks loom large for the upcoming Presidential election” section), we believe the federal land concerns (frack and permit bans)
are more than priced into our coverage based on our analysis. Further, we view DVN and XEC as the most attractively priced, risk-adjusted
stocks in our Bellwether universe.

> Regarding capital discipline and Q320 sector messaging, we expect management teams to pivot further away from growth and towards returns as the sector
prepares for a lower-for-longer environment. As rightfully noted by Travis Stice, CEO of Diamondback Energy, in Diamondback’s Q3 update, “the concept
of production growth should not be discussed until commodity prices recover and global inventories return to normalized levels” as North American shale
producers “have a significant influence on the global oil market, and today that market is oversupplied”. We expect the largest North American producers
to adopt this mindset as the sector prepares to communicate its 2021 capital and operating plans later this year or early next.

> We favor Upstream stocks that can return 100% of their enterprise value within 10 years, given the uncertain medium-to-long-term fundamentals for oil and
gas. Assuming our production estimates and strip pricing, we estimate 10 Upstream stocks, including BCEI, BSM, CRK, DVN, EOG, FLMN, MNRL, QEP,
PHX, and XEC as shown in Figure 3, can do so by 2027, offering significant value now and material upside potential in the future assuming a more favorable
demand outlook. We are increasingly constructive of natural gas as we project a multi-year undersupply scenario as a result of a mismatch between natural
gas’ increasing role in future energy systems and the sector’s underinvestment due to restrictive financial conditions. In light of our macro view, we believe
the investment case for BSM, CRK, DVN, and XEC is exceptionally strong as those stocks could return their enterprise value by 2026.