Oil & Gas Industry Outlook - Aug. 2016

Crude Oil

U.S. oil futures have been very volatile in 2016 with prices recovering from a 12-year low of $26.21 a barrel in February to $50/barrel mark in early June and then slipping again to under $40.

While factors like Canadian wildfires, Nigerian outages/disruptions, production issues in Venezuela and a strike by Kuwaiti oil workers contributed to jump in prices earlier this year that saw the benchmark recover significantly, these issues have largely vanished from the market. As of now, overproduction of crude and a glut of refined products keep the commodity under pressure.

At over 520 million barrels, current crude supplies are up 15% from the year-ago period and are at the highest level during this time of the year. As it is, improvement in oil fundamentals remain fragile with the existing stocks of refined product inventories – gasoline and distillate – remaining at their maximum seasonal levels in at least 20 years despite healthy demand. Piling on the misery is the Baker Hughes report revealing a steady rise in the U.S. oil rig count and pointing to the resurgence in shale drilling activities.

A number of major industry players, including Exxon Mobil Corp (NYSE:XOM). (XOM), Royal Dutch Shell (LON:RDSa) plc (RDS.A) and BP plc (LON:BP) (BP) have reported sub-standard second-quarter numbers as lower energy prices take a toll.

Over the past few trading days, West Texas Intermediate (WTI) crude futures have surged around 10% to around $45-a-barrel on renewed expectations of a production freeze from the 14-member OPEC bloc and Russia. However, several analysts have expressed skepticism over this mini-rally, pointing to the last such attempt made in April that failed spectacularly.

Oil is facing the heat on several other fronts as well. Perhaps most important pertains to the mounting worries about China’s crude demand. In particular, the Asian giant’s currency devaluation has stoked speculation about soft economic growth in the world’s No. 2 energy consumer.

What’s more, in the absence of production cuts from OPEC, the resilience of North American shale suppliers to keep pumping despite crashing prices, and concerns over the effects of Brexit on crude demand., not much upside is expected in oil prices in the near term. Moreover, a stronger dollar has made the greenback-priced crude more expensive for investors holding foreign currency.

As it is, with inventories at the highest level during this time of the year, crude is very well stocked. On top of that, the top producers of Middle East – pumping at full throttle – have indicated time and again that they are more intent on preserving market share rather than attempting to arrest the price decline through production cuts. Therefore, the commodity is likely to maintain its low trajectory throughout 2016.

In our view, crude prices in the next few months are likely to exhibit a sideways-to-bearish trend, mostly trading in the $35-$45 per barrel range. As North American supply remains strong and demand looks underwhelming, we are likely to experience pressure to the price of a barrel of oil.

Natural Gas

"It's cleaner, it's cheaper and it's domestic."

- Legendary energy entrepreneur T. Boone Pickens, in reference to natural gas.

Over the last few years, a quiet revolution has been reshaping the energy business in the U.S. The success of ‘shale gas’ – natural gas trapped within dense sedimentary rock formations or shale formations – has transformed domestic energy supply, with a potentially inexpensive and abundant new source of fuel for the world’s largest energy consumer.

With the advent of hydraulic fracturing (or "fracking") – a method used to extract natural gas by blasting underground rock formations with a mixture of water, sand and chemicals – shale gas production is now booming in the U.S. Coupled with sophisticated horizontal drilling equipment that can drill and extract gas from shale formations, the new technology is being hailed as a breakthrough in U.S. energy supplies, playing a key role in boosting domestic natural gas reserves. As a result, once faced with a looming deficit, natural gas is now available in abundance.

Statistically speaking, the current storage level – at 3.317 trillion cubic feet (Tcf) – is up 361 Bcf (12%) from last year and is 440 Bcf (15%) above the five-year average. Expectedly, this has taken a toll on prices. Natural gas peaked at about $13.50 per million British thermal units (MMBtu) in 2008 but dropped to its lowest level in almost 17 years – at $1.611 per million Btu (MMBtu) – in the first quarter. Apart from plentiful stocks, which hit an all-time high in November, the selloff was spurred by tepid demand for the fuel due to mild weather spurred by the El Niño phenomenon.

In response to continued weak natural gas prices, major U.S. producers like Cimarex Energy Co (NYSE:XEC). (XEC), Cabot Oil & Gas Corp (NYSE:COG). (COG) and Range Resources Corp (NYSE:RRC). (RRC) have all taken significant cost-cutting measures, including a reduction in their capital expenditure budgets.

With production from the major shale plays remaining strong and the commodity’s demand failing to keep pace with this supply surge, natural gas prices have been held back. Industrial requirement has been lackluster over the past few years with demand barely rising. In fact, EIA estimates natural gas inventories will reach 4.042 Tcf by the end of October – a record level for that time of the year.

In the past, winter weather has played a factor in boosting prices with demand for domestic natural gas exceeding available supply. But with no dearth of new supply, even this association is becoming more and more obsolete. Finally, with improved drilling productivity offsetting the historic decline in rig count, we do not expect gas prices to rally anytime soon.

ZACKS INDUSTRY RANK

Oil/Energy is one the 16 broad Zacks sectors within the Zacks Industry classification. We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. (To learn more visit: About Zacks Industry Rank.)

The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #88 and lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative.

The oil/energy industry is further sub-divided into the following industries at the expanded level: Oil – U.S. Integrated, Oil and Gas Drilling, Oil – U.S. Exploration and Production, Oil/Gas Production Pipeline MLP, Oilfield Services, Oil – International Integrated, Oil – Production/Pipeline, Oilfield Machineries and Equipment, Oil–C$ Integrated, and Oil Refining and Marketing.

The ‘Oil – U.S. Exploration and Production’ is the best placed among them with its Zacks Industry Rank #41, comfortably placing it into the top 1/3rd of the 260+ industry groups, where it is joined by the ‘Oil/Gas Production Pipeline MLP’ with a Zacks Industry Rank of #65 and ‘Oil – International Integrated’ with a Zacks Industry Rank of #72.

The ‘Oil and Gas Drilling’ – with a Zacks Industry Rank #97 – moves just out of the top 1/3rd and into the middle 1/3rd. There, it is accompanied by the ‘Oil–C$ Integrated,’ ‘Oil – Production/Pipeline,’ ‘Oil – U.S. Integrated’ and ‘Oilfield Services’ – carrying respective Zacks Industry Ranks of #105, #105, #105 and #170.

The remaining sub-sectors – ‘Oilfield Machineries and Equipment’ and ‘Oil Refining and Marketing’ – are featuring in the bottom one-third of all Zacks industries with Zacks Industry Ranks of #208 and #240, respectively.

The location of these industries suggests that the general outlook for the oil/energy space as a whole is ‘Neutral-to-Negative.’

EARNINGS TRENDS

As is the trend over the past few quarters, a look back at Q2 earnings season reflects that the overall results of the Oil/Energy sector were again very weak, dragging down the aggregate growth picture for the S&P 500 index.

Despite an impressive recovery, crude prices stayed under $50 – about half the level of two years ago – and far below the breakeven price for many energy companies. Moreover, most oil producers have been churning out ‘black gold’ at full throttle, thereby letting the commodity slip.

Before discussing Q3 2016 quarter estimates, let’s take a look at this year’s Q2 earnings season. Earnings fell by a whopping 78.9% year over year, following a 108.6% drop witnessed in the previous quarter. Things have been bad on the revenue front too, which was down 24.4% in the June quarter after declining 29.3% in the previous three-month period.

Predictably, the picture is looking bleak (though better than the recent quarters) for the upcoming Q3 earnings season. This is not surprising, considering that oil has plunged considerably from its recent peak of $51.23 in early June, in the process dragging down estimate revisions. The Oil/Energy sector’s earnings are expected to crash 56.1% from the third quarter 2015 levels, while the top-line is likely to show a drop of 5.0%.

For the S&P 500, earnings are estimated to show year-over-year fall of just 2.6%, while revenues are set to rise 1.9% during the three months ended Sep 30, 2016. This puts the Oil/Energy sector in a bad light when compared to the broader markets. In fact, taking out Oil/Energy from the index, S&P earnings would increase by 0.1%, while revenue would be 2.6% higher from the year-ago period.

For more information about earnings for this sector and others, please read our Earnings Trends report.