Morningstar Magazine - February/March 2015 - 83

With low prices, it's going to lead many majors,
in our estimate, to defer investment on
projects where they think they've suffered cost
overruns. Essentially they'll be playing
chicken with oil services and contractors waiting
for prices to come down on the services
they consume to improve the economics of these
projects. This could really create some major
ramifications, not only for individual stocks
on both the integrated and the oil-services side,
but also for what oil supply growth looks like 24 to
48 months down the road.
Let's talk about the domestic production picture.
Has the fracking trend lost steam?
Hanson: Hydraulic fracturing, what's called

unconventional oil and gas production, still has
legs. I think there's plenty of oil and gas in
the ground. Shale rock, and other types of rock
from which the oil companies extract the
hydrocarbons, it's so pervasive. This stuff can go
on forever. It's just a question of what price
can you receive for your product. So, despite this
temporary hiccup, it's very much a long-term
story to keep your eye on.
What could cause oil prices to reverse the trend they're
in right now?

Should OPEC, which really means Saudi Arabia,
indicate that they're willing to consider a reduction
to existing production quotas or outright cut
production below the current levels of around 30
million barrels a day-that would be a very
bullish sign. It would indicate that prices have
fallen far enough for the titular oil cartels
to be concerned enough to begin to pull supply
off the market. Saudi Arabia has given no
indication of being interested in defending prices
for anybody at this point.
Does the U.S. have the biggest impact on your growth
forecasts or is it China or other emerging markets?

Stevens: Longer term, the demand growth story is
driven almost entirely by emerging markets.
We expect that developed country demand will be
basically flat. However, developing countries,
including China and India, remain very significant
drivers of increased demand, both in terms
of the number of people becoming consumers of
oil through direct travel and vehicle ownership
and through indirect consumption as participants
in their economies.
As the price of oil has dropped so, too, have the
prices of oil-related stocks. Are there parts
of the energy sector in particular that are taking
it on the chin?

Stevens: Markets right now are still taking every
piece of news as a reason to sell. There
aren't a lot of buyers because no one believes
the story has played out. And the reason no
one believes the story has played out in the short
term is that it takes a while for information
to filter through. The next thing everyone is going
to be looking for is first, how much do U.S.
E&Ps cut their capital spending for 2015, and
second, how much activity and resultant production do those capital spending cuts bring
out of the market. Really, what all that is trying to
serve as is a proxy for when will supply correct
downwards to become more aligned with demand.

The overly leveraged, high-cost companies that are
getting hit right now, they tend to be smaller-cap firms?

So, if we see outsized downward revisions to
capex budgets in mid- to late January as upstream
companies begin to publish their 2015 capital
budgets, then that could serve to stabilize
oil prices. But I don't think that in itself would be
enough to bring them back up until markets
feel confident that supply and demand are coming
closer into equilibrium.

Hanson: They do. They tend to invest a lot of a
well's cost in the first two or three months.
So, let's say a well costs $10 million over the next
30 years. A company might spend $5 million
of that in the first three months. So, these
small firms are always overspending the cash
that's coming in the door, and that leads to
generally having to either a) issue equity, b) sell
assets, or c) issue debt.

Hanson: Upstream oil and gas. If you think about
the value chain, the guys that are actually
going out, assembling the land, drilling for oil and
gas-they're most directly connected to the
price of oil, just in terms of how they make their
money. They are the ones that have probably been
hit the hardest. In particular, E&P companies-
those that have a lot of debt and those that have a
higher cost position. You're talking about
stock prices down 50% to 80% in some cases.

If these companies struggle will they get bought
by larger competitors?

Hanson: If oil prices stay low, a lot of firms aren't
going to be around, either voluntarily or
involuntarily. Who are the likely buyers here?
Who are the likely sellers? There are a lot
of smaller, privately held companies that you've
never heard of. Maybe the company has a
handful of acres in West Texas. At these prices,
the company can't afford to take the kind of
risk of one or two bad wells because they would
be out of business.

So, that company might sell to a consolidator
in the Permian Basin, which is one of the
big three producing areas right now. In terms of
consolidators, I would include companies such as
Concho Resources CXO, Occidental OXY, and
Devon Energy DVN. I would also say Apache APA.
Those are the kinds of names that have the
financial firepower.
Stevens: After the E&Ps, the segment of our
coverage list that will likely see the most pressure
to their share prices would be the oil-andgas services companies, particularly those firms
leveraged to either land services, drilling,
well completion, pressure pumping, here in the
U.S. and Canada, or those leveraged to providing
deep-water services to megaprojects that
are likely to get deferred as prices are low and
capex gets cut. So, while oil-services firms
have sold off probably in the 15% to 35% range
depending on each individual company,
there's reason to expect these stocks to leg down
again as E&Ps formalize their 2015 budgets.
Basically, buyers will be getting assets on the cheap?

Hanson: That's one of the few advantages
of being a bigger player in upstream oil and gas.
There are not a lot of advantages, believe it
or not. The smaller guys compete very effectively
with the big guys. But during periods of low prices
those with the deeper pockets-that's where
being big really helps.
Stevens: Right now, if you had assets that were
high quality in an $80-plus oil environment,
you absolutely don't want to be a seller of those
assets in a $60 environment. Some firms will
face an existential crisis here, literally existential in

global.morningstar.com/Morningstarmagazine

http://global.morningstar.com/Morningstarmagazine

Morningstar Magazine - February/March 2015

Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2015