By George Mack of The Energy Report (4/17/12)
For Morgan Stanley Analyst Evan Calio, a challenge is really an
opportunity, at least when it comes to finding discounted equities in
the oil and gas space. In this exclusive interview with The Energy Report,
he explains why the distribution bottleneck that is causing a
historically wide price differential between WTI and Brent is actually
an opportunity for refiners and Americans everywhere.
The Energy Report: Oil and gas controversies are all over the news these days. Evan, what is your take on the space?
Evan Calio: Energy is a challenging space currently. The biggest story right now is the widening West Texas Intermediate (WTI) discount to water-borne, global crudes like Brent, largely as a result of unconventional oil production growth in the U.S. Our five-year forecast for U.S. oil liquids production growth is 2 million barrels per day (MMb/d). You could add some of the Canadian barrels that ultimately should travel into the U.S. refining system of almost 700 thousand barrels per day (Mb/d). That is a pretty material amount of production growth on a relative basis and could result in increasing U.S. oil independence. Not since the late 1960s have we seen that type of relative oil production growth.
Production growth has been a big boon to the midstream infrastructure space that constructs the pipeline architecture and then moves the crude to new areas. It has also been a significant tailwind for the U.S. refining sector, which has been the best performing energy subsegment for the last three years running. Seasonal strength in the refining trade has been exacerbated, which led to some recent negative price movement. Overall, the U.S. production growth and the latency of the midstream architecture and the relatively low cost of natural gas in America are all things that have turned the U.S. from its historic role as a net refined products importer in 2008 to a significant net exporter today. We are taking market share at much better profitability than some of the traditional global refiners.
The crude production story is also impacting our names on the upstream side. Essentially, it's providing them with incremental growth profiles versus what they've had historically. I think some of that is offset by lower gas production driven by lower prices. It has also led to an increase in overall capital expenditures coming into this year. A combination of fear of current oil prices, possibly lower natural gas prices and higher costs have acted as a headwind to that sector so far this year. That is driving the outperformance in the refining sector and will help the upstream oily names at some point this year.
TER: What caused the price differential between Brent and WTI?
EC: Greater production in North America built up before infrastructure was available to move it to the water and on to places with big refining sectors. The midcontinent region of the U.S. is primarily a net importer of refined product so it is set to global pricing while the crude feedstock costs are local and discounted. It has been a big earnings boon to the U.S. midcontinent refining system. The U.S. independent refiners have some exposure to this midcontinent phenomenon so they can access those discounted crudes. That is really helping them.
TER: Why hasn't the spread between Brent and WTI narrowed as infrastructure kicked in?
EC: It is narrowing a bit. However, there have still been too few direct connections between Cushing, Oklahoma, and the U.S. Gulf Coast. As we move into June, the 150 Mb/d Seaway connection will go into service. It is in the process of being reversed; it used to go from south to north and now it's going to go from north to south, from Cushing to the Gulf Coast. That will be the first direct pipeline access to the Gulf but it is still not enough to handle all the excess production.
The reason that the spread has remained wide is because there is no easy way to arbitrage it. If there was a limitless pipeline that connected Cushing to the Gulf Coast, the price differential between Cushing and the Gulf Coast would be equal to the cost to ship on that pipeline. The Seaway reversal could result in a $4 downside to the spread short term, but in the back half of the year, it will begin to widen out to around current levels. That is our forecast for the WTI-Brent spread in 2012. In 2013, Seaway could more than double capacity and eventually move 800 Mb/d, which would compress the price closer to the cost of the marginal barrel out of a particular basin. Tariffs on new lines could keep prices above historic differentials for the long term.
Originally, the plan was for Keystone XL to take 500 Mb/d of crude from Hardisty in Canada all the way to the U.S. Gulf Coast where higher complexity refiners can process heavier crudes. Now with that pipeline blocked, a path is essentially being cobbled together in reverse. This will result in a lot of other differentials around the country until freer access is built to the Gulf Coast. This year we could see similar problems around lack of takeaway capacity in the Permian Basin. The Permian is now trading $8 under WTI; it used to trade less than $1 under WTI. People who can access that crude have an advantage. The Bakken is trading at a wider differential to WTI, and WCS (Western Canadian Select) is trading at the widest differential. Transporting crude by train can cost $15/barrel (bbl).
There is a lot of optimism around the Utica in Ohio. Its potential shale formation will get more data from well results over the next few quarters from Chesapeake Midstream Partners L.P. (CHKM:NYSE) and Anadarko Petroleum Corp. (APC:NYSE). The problem is that this will be another area that doesn't currently have significant transportation architecture. That could result in incremental midstream pipe-building, gathering and processing, which is pretty bullish for us.
TER: When you say bullish for us, you're talking about your segment?
EC: I'm talking about you and me, the American people. In the U.S. right now, we pay a significant overall natural gas cost differential. Natural gas is around $2/thousand cubic feet equivalent (Mcfe). Liquefied natural gas (LNG) is $14/Mcfe on a contract basis and $17/Mcfe on the spot market. It's $10/Mcfe in Europe—that is a significantly cheaper hydrocarbon molecule. Eliminating 2 MMb/d of crude imports will impact the U.S. balance of trade and provide a lot of jobs because these molecules are a little bit more labor intensive to produce. An American Petroleum Institute (API) study released in September showed that if the U.S. changes the way it regulates hydrofracks, it could create 670,000 jobs and increase domestic tax and royalty revenues. It could also benefit the service industry by expanding demand for rigs, trucks and these kinds of things. So when I say it's bullish, I say it's bullish for America, bullish for you, bullish for me, bullish for our kids.
TER: I realize that volumes are the drivers for the midstream and the downstream, but your commodity specialist is forecasting Brent at $105/bbl. That sounds bearish to me. How do you strategize around that?
EC: The commodity curves are very backward dated, meaning that the futures prices are significantly below the front-year pricing. Some of this supply-driven tightness relates to geopolitical problems, which remove supply from the market and is fundamentally different than demand-driven strength. It happens almost every year. The Arab Spring drove Brent crude to $125/bbl last year just as the Iranian crisis did this year.
So what do you do? When everyone believes the oil price is going to drop and the stock prices reflect a drop that exceeds the drop in the commodity, then you are reaching valuations at which stocks become interesting. I think we are getting to those levels.
With most of the market, it's been better to be defensive and be in lower beta, better balance sheet equities in terms of the integrateds with some dividend support. Chevron Corporation (CVX:NYSE), Exxon Mobil Corp. (XOM:NYSE) and ConocoPhillips (COP:NYSE) are being relatively lower weighted for everything else within energy. Part of it is driven by the fact that the market isn't paying for overall supply-driven oil, especially once it got to a $125/bbl level, a place that would run risk to the tape. Plus, a warm winter and lots of associated production have resulted in significant underperformance.
TER: Evan, can we talk about some of the stocks that you're talking to your clientele about?
EC: One stock that's been a big call for us is Cobalt Energy Group (CIE:NYSE), a 100% exploration stock. It has almost tripled from when we recommended it in late December after initial data was released on a discovery in Angola. We were the most vocal on the stock into what I think was a transformative discovery in the Angolan pre-salt play.
TER: Are you still very bullish on it?
EC: Yes. We're overweight. The next catalyst will be an appraisal well result in the May–June timeframe. It is unique because it will be drill-bit driven rather than commodity- and macroeconomic-dependent. We think it can clearly double from here. I see a lot of value support in the continued drilling and proving up of the resource in Angola in delineating its prospects in the Lower Tertiary, which is the Gulf of Mexico, and the Lower Tertiary pre-salt play. If we get our first well in the back half of the year in North Platte at $6 to the net asset value (NAV) of the stock, it will derisk six other prospects as well as a bigger inventory on that play concept. North of Angola is a very interesting block where Cobalt is participating with Total S.A. (TOT:NYSE) on a well in Gabon. It should start drilling this year, but you'll get results into 2013 that are three or four times the value of Angola in terms of a per barrel basis. We're talking about a multibillion-barrel prospect. So it's a mid-cap company that is entirely unique in our view.
TER: It's interesting. Over the last 12 weeks, it's up 60%. And after all of this activity, up 227% over the past six months; it didn't even give back a lot over the past month.
EC: It did a big private equity offering at $28. That added to the stop. It's a range-bound stock until we get incremental drill results. We think there's a lot of promise there and significant value for an $11B company. This isn't a tomorrow story, but over time it will still be a core piece of my portfolio.
TER: Another one?
EC: Right now we like Sunoco Inc. (SUN:NYSE), which is transforming into a general partner (GP) holding company structure akin to a Kinder Morgan Energy Partners L.P. (KMP:NYSE). Sunoco was a refining company and held a bunch of different assets. A newer CEO came in to divest all of the assets. It's a stock that's in transition. It is currently covered by folks who cover the refining entities, but in about six months it will be covered by midstream analysts. So it is going from what was a sum-of-the-parts restructuring story to a yield-driven GP holding company, a C-corporation that owns the GP and limited partnership (LP) interests in a master limited partnership (MLP) called Sunoco Logistics Partners L.P. (SXL:NYSE). It will own a marketing business. This will make it very ratable and not as volatile as anything else in energy.
TER: While it is restructuring, what is supporting this stock?
EC: It's a yield support based on the value of the underlying assets. So the value includes the GP and the LP interests in Sunoco and a 4% pro forma dividend yield, versus a current yield of 2%. The company also has a buyback for 20% of its shares outstanding. We think that once it gets through the refining sale, it will be able to reload and buy back another 20% of its stock. The yield is based on transportation revenues, which is in a steady revenue stream. The dividend is based on marketing earnings, which is actually inversely correlated to oil price. In fact, the best year was 2008, when the oil price went down and the company made $400M earnings before interest, taxes, depreciation and amortization. We are forecasting $220M next year. Sunoco already spun out SunCoke Energy Inc. (SXC:NYSE), which was $7–8/share. The stock is really trading around the $45 range, including the SunCoke distribution. We see almost $10 of upside in the stock. It is 100% or largely an oil-to-liquids play. The MLP by itself is attractive. It's a safer type of trade.
Another stock we recommend is Hess Corp. (HES:NYSE). Now we're moving into something that is going to be more predicated on the overall commodity price level, primarily the Brent oil price. Hess is more of a GARPy (growth at a reasonable price) story. The company has significantly underperformed majors over the last 12 months; a lot of things really went wrong, but we think all those things will improve going forward. Last year was the wettest year in history in the North Dakota Bakken, where the company has a big unconventional growth play, leading to slowed activity. Weather should be much better this year and that will correlate to production growth. Hess also suffered from the price differential situation we discussed earlier. That should decrease, as should capital efficiency, now that it has set up a rail system and drilling pad. Although another gas-handling plant will have to be paid for this year, the billions spent for Utica acreage will be a net asset value going forward. Finally, the shift from offshore exploration to higher probability prospects should pay off in the next 12 months. We are looking at a 2013 growth rate approaching 10%. When things get better, we think it makes sense to buy. Particularly down here at $55, it's a price-to-book level, the lowest since 2003.
TER: What's a near-term catalyst for Hess?
EC: An unpredictable catalyst is when the company engages in some asset sales to fully fund overall capital spending for 2012. The kicker with a lot of these upstream stocks is that there are few catalysts that are predictable.
TER: You are following Bonanza Creek Energy Inc. (BCEI:NYSE). I'm interested because it's a small-cap stock. What is your opinion of it?
EC: We really like it. It came into the market at a cheap price and made a lot of operational momentum through the core on the Niobrara shale formation. Our target price is $23 at this point. I think it was very inexpensive in the $14 level. We'll have to see. Its success will depend on how the play develops and how the company solves some of the variability issues across the Niobrara, of which we are constructive.
I also cover Delek U.S. Holdings Inc. (DK:NYSE), Alon USA Energy Inc. (ALJ:NYSE) and Western Refining Inc. (WNR:NYSE). Those are all smaller-cap refiners. Delek has a lot of projects. It's going to help deliver Permian Basin crude into its refining system, which will be price advantaged. But I think Delek is in a similar boat, as all the refiners are exiting a period of significant seasonal strength. A year from now, they will probably all be at a higher level, but in the short term, we see downside risk.
TER: Is there anything you love that you haven't spoken about yet?
EC: In refining, I like HollyFrontier Corp. (HFC:NYSE). Its earnings achievability for the full year is the best among all the refiners. It's essentially paying a special dividend on a quarterly basis that we believe is sustainable, based on projected cash flow for the next five years. That yield is implying a 7.5% overall cash-flow yield. We're going to see $2B of cash on the balance sheet by year-end. The MLP value is a little bit under $1B for a stock that is $6B. Its implied valuation of the assets is significantly compelling. It will be running 30% WCS. We think that those differentials will remain the widest for the longest. That will be the last differential solved as the pipeline capacity begins to build out farther south. It's a great business with a very disciplined cash return that's earning the most money with high free cash flow. It's just a very attractively situated midcontinent asset. The CEO is buying it under $25/share. Now it is breaching $30/share. This is one that we would want to buy.
TER: Any final words of advice for investors?
EC: Energy is in a tough spot right now. We believe in refining, earnings achievability and investing on seasonal weakness.
TER: I've enjoyed meeting you very much, Evan. Thank you for your time.
EC: Thank you.
Evan Calio is an executive director in equity research at Morgan Stanley and is the lead analyst for the integrated oil, large-cap E&P and refining industries. Prior to joining Morgan Stanley in November 2008, he was energy specialist at JP Morgan Securities, managing energy risk and proprietary positions. Before that, Calio was an investment banker at Morgan Stanley in the Global Energy & Power Group and the Execution Group, primarily covering refiners, integrated oils and national oil companies. From 1995-99, Calio was an attorney and a special counsel for the U.S. Securities and Exchange Commission's Division of Corporation Finance. He has an Master of Laws (cum laude) from Georgetown Law Center, a Juris Doctor from the Widener University School of Law and a Bachelor of Science in finance from Lehigh University.
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DISCLOSURE:
1) George Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None. Streetwise Reports does not accept stock in exchange for services.
3) Evan Calio: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this story. See additional disclosures.
( Companies Mentioned: ALJ:NYSE, BCEI:NYSE, CVX:NYSE, CIE:NYSE, COP:NYSE, DK:NYSE, XOM:NYSE, HES:NYSE, HFC:NYSE, SXC:NYSE, SUN:NYSE, SXL:NYSE, WNR:NYSE,)
Source: The Energy Report
