Morgan Stanley's take on the Energy Sector - July 12

[dan_s]

Received this morning from Morgan Stanley Equity Research

Oil & Gas | North America
Demand Risks Drive Continued Volatility

Increasing recession fears have driven Energy >20% lower in
the past month, the largest 4-week drawdown since the
financial crisis. Despite demand risks, industry fundamentals
skew constructive & stock valuations are compelling even at lower
prices. We expect strong 2Q results to be a positive catalyst.

Recession fears continue to drive Energy sector volatility. Since peaking in early
June, the S&P Energy sector has fallen by >20%, underperforming both oil and
the broader market. Outside of the covid-driven collapse in 2020, this is the
largest 4-week drawdown in the sector since the 2008 financial crisis. Unlike
prior large sell-offs in 2008 & 2014, this time around equities have far outpaced
the move lower in crude. With consensus expectations for GDP falling,
manufacturing PMIs rolling over, and consumer confidence waning, concerns
about demand destruction have been building. However, the supply-side remains
supportive with low OPEC+ spare capacity, global underinvestment in oil & gas,
and moderated US production growth relative to prior cycles (see Assessing US
Shale Growth). Further, EU sanctions on Russia, US SPR (strategic petroleum
reserve) releases ending, China re-opening & stimulus initiatives, and still
recovering air travel should all support a tighter oil market later this year.

Looking ahead, we see 2Q earnings as a positive catalyst for the sector and
expect another quarter of earnings growth and record FCF to support a further
acceleration of shareholder returns initiatives.

Is demand destruction materializing? With elevated refined product prices in the
US, including gasoline still near record levels, total domestic demand has shown
some weakness recently. Gasoline supplied over the past four weeks has
averaged 5% lower y/y, with distillate showing a similar decline (although both
showed a recovery last week). That said, despite the decline, gasoline is still
trending in-line with the 5-year average. Meanwhile, in jet fuel, a key end-market
that has not yet fully recovered its covid losses, demand continues to trend
higher.

Putting it all together, total US product demand has averaged ~4% lower y/y
over the past four weeks.

In his base case, MS oil strategist Martijn Rats forecasts 3Q global oil demand
to be ~2.7 MMbbl/d higher than 2Q, driven by China reopening and rising air
travel.

With consumption still recovering to normal levels, "demand risks" likely
materialize in the form of a slower growth rate rather than an outright
decline in total global consumption - leaving the oil market tight and
supporting oil prices.

E&P and Integrated Energy stock valuations remain attractive even at lower oil prices.
After the sell off, E&Ps and Integrateds/Majors (which combined represent ~75% of S&P500 Energy) trade at ~65% and ~55% discounts to the broader market, respectively. This is wider than nearly any time in the past decade. Intrinsically, we estimate that the sector is now only pricing ~$60/bbl WTI - a steep discount to the futures curve which averages ~$86 over the next 2years. Assuming $90/bbl WTI next year, we estimate our E&P coverage offers a median FCF/equity yield of 17%. Should oil prices move $20/bbl lower, the sector would still yield 11%, double the broader market. Strong2Q earnings should bea positive catalyst for the sector. On 7/1, XOM released its 2Q earnings considerations, which highlight planned and market factors affecting its quarterly results. Higher oil & gas prices imply ~35% higher upstream earnings q/q, while higher crack spreads suggest downstream & chemicals net income could increase >4x from 1Q. We expect this positive trend to extend to the rest of the sector as companies report 2Q results. With balance sheets already in good shape (0.4x avg.2022net debt/EBITDA), another quarter of strong FCF should drive a further acceleration of shareholder returns initiatives - a key differentiator versus prior cycles (and many other sectors in the market) and potential catalyst to help re-rate overly discounted valuation. Notably, the median total yield (dividend + buyback) across our coverage is already at an attractive ~8% this year.