Slightly over a year ago, the price of oil plummeted to a cyclical low of $27 per barrel. Here’s good news: Oil is in recovery — not a steady recovery, mind you, but one that will hit a price peak of about $70 by year’s end, says Pavel Molchanov, energy equity analyst at Raymond James & Associates, in an interview with ThinkAdvisor that includes his top oil stock picks.
Yes, oil inventories are down because of companies’ production cutbacks. But what Molchanov is watching carefully, too, is another key indicator: oil companies’ capital spending, which, over the past three years, saw an enormous 60% in investment reductions.
Molchanov, RJ’s energy analyst for 14 years, is indeed bullish on oil in light of the recovery. But he is hardly upbeat in his outlook for natural gas this year. That energy source is still suffering from oversupply and reduced demand.
During Barack Obama’s presidency, America became the world’s fastest growing producer of oil and gas, as well as a substantial generator of wind and solar power. Coal was a loser, largely because natural gas replaced it. A decade ago, coal had 50% of the electricity market; now it takes only about a third of market share, according to Molchanov.
In the interview, the RJ senior vice president, based in Houston, talks about whether President Donald Trump can save the coal industry and names several oil companies that he favors. He also discusses the chances of America’s becoming energy independent, among other issues. Here are highlights of our conversation. (Disclosure: Molchanov spoke in his capacity as an analyst, not as a financial advisor.)
THINKADVISOR: What are your expectations for oil?
PAVEL MOLCHANOV: Bullish is exactly the right word. We’re looking for oil to reach a cyclical high around $70 a barrel for WTI (West Texas Intermediate Grade) by the end of 2017. But we’re not expecting it to stay at $70 forever. That would be too high, in fact. In the long run, it should be coming down toward a longer-term rate of perhaps $60.
And what do you forecast for the price of natural gas?
We’re not nearly as upbeat about that. Unlike the global oil market, which is in recovery mode, we think that U.S. natural gas prices will remain quite depressed. Gas supply is growing. We’re forecasting an average price of less than $3 [at] Henry Hub over the next twelve months. We’re much more positive on oil industry fundamentals because supply is still struggling to keep pace with growing demand.
Why do you anticipate oil prices going as high as $70?
U.S. oil inventories are way down, though the decline wasn’t as rapid as some had expected. We think that global inventories are probably coming down even faster than in the U.S. Real-time data on that won’t be available till later in the year. We expect inventories everywhere to be falling at a faster rate in the second half than in the first.
One of the reasons oil inventories have been shrinking globally in recent months is because OPEC implemented production cuts as of January. Right now there’s debate within OPEC as to extending the agreement beyond June 30 for another six months. [On May 25, OPEC extended the cuts to March 2018.]
What else do you take into consideration when forecasting the oil market?
The most important trend we’re keeping track of is how oil producers the world over are approaching their investment strategy. Oil companies have been retrenching during the absolutely epic downturn that we’ve seen over the last three years. In 2013, global oil and gas investment was about $600 billion. This past year, it was down to less than $300 billion.
What does that mean to oil production?
If companies don’t invest in oil and gas fields, production falls. If companies are slashing their investment — capital spending — left and right, that means less drilling, which means less production.
Just how bad was the downturn?
Painful. We’ve had three consecutive years of cutbacks in global oil and gas investment, and each cutback was steeper than the one before. That’s extraordinary. Oil and gas investment globally plummeted 33% in 2016. That’s the steepest one-year decline since the beginning of the century — and maybe since the 1980s.
What about the immediate prior years?
In 2015, it was also down 26%. Even in 2014, when [oil production] peaked, it began to fall. Global investment was down 7% that year. From 2013 to last year, the total reduction was approximately 60%. In 2013, global oil and gas investment was about $600 billion; this past year, it was down to less than $300 billion.
But are companies now increasing their investment?
Yes, but at a very slow, subdued rate, based on budgets. That’s according to what the companies are telling us. When we aggregate all the capital budgets, we see 2017 investment recovering by only 13%. That’s not much of a recovery.
What’s going to prompt companies to step up their willingness to drill and invest more?
Higher oil prices. Just about every oil producer the world over has a balance sheet that’s more levered than it was five or 10 years ago. So continuing to borrow and live beyond their means isn’t an option.
What oil companies do you like?
Our focus is on companies with leverage to strong leverage, to oil price recovery: On the large-cap side, drilling companies or E&P [exploration and production] companies like Pioneer Natural Resources, Marathon Oil, Occidental Petroleum and Halliburton.
And on the small-cap and mid-cap side?
Some of our best ideas would be Oasis Petroleum, Kosmos Energy and Superior Energy Services. All of those companies are significantly tied to oil prices.
What’s your forecast on earnings for these companies, and for other oil companies?
We think 2017 will be much better than 2016 and that 2018 should be better than 2017. If companies are levered to oil — not to natural gas — then, of course, a rising tide lifts all boats. The ones I mentioned are particularly focused on oil.
What are your expectations for the natural gas market, then?
Unlike the global oil market, which is in recovery mode, we think that U.S. natural gas prices will remain quite depressed. There’s definitely too much supply. But even more importantly, demand is simply not materializing at the rate the industry would have liked.
What’s the status of the U.S. as an energy exporter?
The U.S. is already a natural gas exporter, since last year.
Technically, some oil is being exported, but relatively small quantities. The amount of oil the U.S. is importing is much greater. When we net it out, the U.S. is the second biggest importer of oil in the world behind China — because the U.S. is the biggest consumer of oil in the world. The U.S. consumes twice as much oil as China despite having a much smaller population.
Can America ever become oil independent?
Since 2010, the U.S. has added more oil supply than any other country, largely because of [innovative] fracking and horizontal drilling [techniques]. That was obviously a good thing for the companies that were able to increase their productivity and the value of their reserve. But all that extra supply contributed to the meltdown in oil prices that occurred in 2015 and 2016.
But doesn’t that still point to America’s becoming energy independent one day?
A decade ago the U.S. was importing two out of every three barrels being consumed. This year, it’s going to be one out of every three barrels. So, it possibly could be completely independent but not anytime soon because it’s the biggest consumer by far.
Why has coal been losing so much market share in U.S. electricity?
The reason coal has been in freefall is because of cheap natural gas. During the Obama years, a lot of natural gas production went into replacing coal.
Who’s gaining coal’s share now?
Renewables are taking at least half the share that coal is losing; in some years it might have been as much as two-thirds. In 2016, two-thirds of new power plant construction was for wind and solar [energy]; one third was natural gas. Further, coal power plants are being retired.
It seems that, from what he says, President Trump is trying to save the coal industry.
He can pay lip service to saving the coal industry, but it’s beyond his capabilities or those of [any branch of] the U.S. government because ultimately, electric utilities are making decisions based on economics. Natural gas is so much cheaper than it was eight years ago, and that’s not going to change.
Does the economics factor relate to alternative energy sources too?
Yes. Wind economics are dramatically better today than eight years ago; solar economics have improved at an even faster rate than they were eight years ago. So for all those reasons, we’re seeing the shift in electricity generation away from coal and toward gas — and increasingly, wind and solar are outcompeting gas for gaining share.
Is that on a global basis too?
Yes. We’re seeing it the world over. Coal, for example, is losing share in the emerging markets of China and India. And there are countries whose government has officially committed to dismantling coal generation completely. In Britain, Canada, Austria, Finland and some smaller countries, coal is being phased out entirely.
So Trump’s stated intentions regarding coal don’t matter very much?
I don’t think there will be much change from these underlying trends during Trump’s first term because they’re fundamentally economic trends rather than something that was politically driven.
The president says he supports all forms of energy and that energy independence is a priority of his. Your thoughts?
Well, supporting U.S. oil and natural gas production, and wind and solar electricity already started happening during the Obama administration. Coal has been on the losing side.
How strong is China’s demand for oil?
Global demand is in pretty good shape, and China is the big reason for that. It’s not growing as fast as it was 10 years ago, at 8% to 10% a year; currently it’s more like 3% a year. But that’s still very good for an economy as big as that.
Is there another major country in which oil demand is growing faster than China?
India is the only one. We’re also seeing strong oil demand grow in Africa, but that’s a smaller base. What’s driving demand in all three of these countries is the middle class buying more cars, people moving into cities from the countryside, more airline traffic [and so on].
What do you think about investing in integrated oil and gas companies?
When prices are rising, it’s better to focus on the pure-oil levered companies. So one like Exxon wouldn’t be something we’d recommend.
Is it a good time to invest in master limited partnerships?
In general, pipeline [midstream] companies aren’t directly priced to the level of oil prices because they’re fee-based businesses. Still, as U.S. oil production recovers with higher oil prices, this will benefit midstream suppliers.
Any MLPs on your “like” list?
On the large-cap side, we like Kinder Morgan, which is a good example of a company that benefits indirectly from rising oil prices.
I’d venture to guess that companies in the U.S. aren’t looking for new shale locations to drill.
I don’t think there will be need for finding any new basins, but there could be opportunities in Alaska, California or the Gulf of Mexico — not necessarily fracking-related.
When will electric cars sales impact oil in a meaningful way?
Sales of electric vehicles are reaching critical mass. It’s a market growing from a very small base. About 1% of the 80 million cars sold [worldwide] last year were electric. But [the number] is growing and growing rapidly. As far as oil demand goes, [electric vehicle sales are] eventually going to become needle-moving but not until well into the next decade.
How significant is the Keystone pipeline, used for transporting oil from Canada to the U.S.?
The Keystone has nothing to do with the U.S. becoming energy independent in its oil supply. It’s been a bizarre political hot potato for years and became a symbol for climate-conscious consumers. But during the Bush, Obama and even the Trump administration, dozens and dozens of pipelines have been approved without any kind of controversy. No environmentalists even noticed. People just didn’t care.
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