Energy Prospectus

From the Morningstar Equity Research Team

Crude oil prices are down sharply in recent weeks, and with them, energy stocks. We understand the
crude market’s reaction to worsening short-term fundamentals, but feel that equity markets have overreacted,
misinterpreting how lower prices will affect cash flows for oil and gas firms. We think the
20%-30% sell-off in energy stocks is overdone, even if you assume WTI prices fall to, and remain at,
$75 per barrel through the end of 2016. In this report, we provide an overview of deteriorating
fundamentals, explain why this situation is shorter term than the market seems to believe, and then
examine what impact $75 crude oil would have on our oil and gas coverage. Our answer is that
$75 WTI through 2016 would lead to 5%-10% reductions in fair value estimates across oil-weighted
E&Ps and services companies, suggesting that investors focused on stock selection can now buy quality
franchises at 15%-20% discounts.

For oil-weighted E&Ps, we think Apache, Devon, and Whiting are solid operators selling for 30% below
our $75 WTI scenario fair value estimates. We continue to favor BP and Exxon among integrated peers
and see minimal downside risk for integrateds as a whole in a $75 oil scenario despite a 13% overall selloff
in the past month. Among services firms, Schlumberger, Core Labs, and National Oilwell Varco are all
wide-moat services firms now trading at 25%-35% of our estimate of intrinsic value even if lower oil
prices prevail over the next two years.

I would add most of our model portfolio companies to the list of great values. - Dan

Key Takeaways
× Surging crude oil supply, weakening demand, and the strengthening U.S. dollar resulted in a 13% drop in
global crude oil prices in the past month and a 24% drop from their 2014 peak of $107/bbl, a reflection of
near-term fundamentals, not longer-term supply and demand trends, in our view. Our estimates of $90
WTI/$100 Brent midcycle oil prices remain unchanged.
× The 20%-30% sell-off in shares of oil and gas firms is a disproportionate response to oil price
fundamentals and out of line with valuation impacts in our view. In contrast, we test $75 WTI/$80 Brent
through 2016 and find that the fair value estimates of most energy companies would drop 5%-8%
compared with their valuations at current strip prices.

Depending on how you measure it, energy stocks are cheap. The Vanguard Energy ETF, which earlier this year was up 15% and ahead of the Standard & Poor’s 500 Index, is now back where it started as crude prices have plunged to $80 a barrel on signs of a global oil glut.

Time to get in?

“My view is we’re at the bottom, and this is a brilliant entry point,” said Tim Guinness, manager of the Guinness Atkinson Global Energy fund, with about $400 million in U.K. and U.S. assets.

Read: http://www.forbes.com/sites/danielfishe ... r=yahootix