Analysts Expect E&P Earnings, Cash Flow to Hit Record Levels in 2005
Exploration and production (E&P) companies' earnings and cash flow this year are expected to be at or above record levels, up 10-15%, driven by commodity price and refining margin strength, said CreditSights analysts in a new report. And investors' recognition of price sustainability will lead to another banner year for investors, according to Raymond James' analysts.
Gas prices are expected to average $7.25/Mcf, said Raymond James' J. Marshall Adkins, Jeffrey L. Mobley and Wayne Andrews in the latest "Stat of the Week." That is a higher level than most forecasters, and about $2 higher than the Energy Information Administration's latest forecast for 2005.
For 2005, the Raymond James analysts forecast the low $40s/bbl range for oil, with U.S. gas prices moving toward a 6:1 ratio with oil prices. Normally, the average oil/gas price ration would be 5.5:1, "but given the larger-than-expected current gas storage volumes due to the mild 2004 summer, this ratio may not materialize in 2005." Assuming Btu parity of 6:1 and the oil forecast, Raymond James is setting the fair value for gas in 2005 between $7 and $7.50.
Since bottoming near $4.50/Mcf in September, "prices have staged a massive rebound, peaking above $9 in October," said Raymond James' analysts. "While the recent drop in oil prices spilled into the gas market as well, gas market pricing remains strong. We remain bullish on long-term gas fundamentals." Over the long term, the analysts said gas prices should return to the 5.5:1 crude oil to gas price ratio, which could "easily" be achieved with a normal to colder-than-normal winter weather scenario. In this case, they said at $40/bbl, the 5.5:1 ratio would set gas prices in the low $7s/Mcf range.
"We expect domestic gas supply to fall by 2% to 4% per year over the intermediate term," said Raymond James' analysts. "That, plus a strong U.S. economy and favorable fuel-switching ratios, should eventually result in gas prices trading at or near Btu parity with petroleum liquids."
For exploration and production (E&P) and oil service stocks, the Raymond James analysts noted that the energy stocks had "massively outperformed" the stock market in 2004, and further strength is expected this year. "We are projecting that the E&P Index may gain up to 30% in 2005," they said, and rising E&P cash flow "should lead to continued growth in capital expenditures, particularly on drilling. After a nearly 25% year-over-year increase in capital spending for our E&P coverage universe, we are looking for another 20% to 25% in 2005."
Along with strong year-over-year earnings growth, the CreditSights analysts believe current price estimates are too low, which would leave "ample" room to revise earnings upward in the next few months.
The positive earnings momentum will allow the energy industry to continue to outperform the broad markets in 2005, said analysts Brian Gibbons Jr. and Spencer Siino.
"Our analysis shows that six of the 19 companies in our coverage universe will finish 2004 with over $1.0 billion in cash and 14 companies are poised to have over $1.0 billion in cash on the balance sheet by end-2005, based on our operating cash flow and capital spending expectations," said the analysts. "The average cash balance as a percent of market capitalization is expected to be 15-20% versus a 10-year average of 2.5%."
The analysts said most of the companies throughout the industry are expected to begin "significant" share buybacks and dividend increases, followed by debt reduction and incremental capital spending increases. They don't expect any big increases in merger and acquisition (M&A) activity, "given high asset valuations, the completion of asset repositionings following the late 1990[s]/early 2000[s] M&A boom, and restructurings undertaken more recently in 2004."
Companies expected to be the "leaders" in capital spending increases, share buybacks, dividend increases and debt reductions with the highest cash-to-market cap ratios for 2005 are "likely" to be Devon Energy, Burlington Resources, ConocoPhillips and Occidental. Also high on the list are Anadarko Petroleum Corp., Schlumberger and Sunoco. Those most likely to pay down debt are Devon, Halliburton, ConocoPhillips, Kerr-McGee and Valero, the analysts said, while those most likely to increase spending are Occidental, Murphy, Unocal, Valero and Anadarko.
"We expect operating cash flows to be 10-15% higher in 2005 with the Integrateds and E&Ps benefiting from production growth and improved commodity price realizations, and the Oilfield Services players benefiting from higher producer spending." Cash flow for Refiners is expected to be "marginally higher" because of a flat refining margin tape. Capital spending should be 10% higher for the Integrateds, said the analysts, matching service cost inflation, and 10-25% higher for the E&Ps, leading to sizable revenue growth for the Oilfield Service industry. The analysts noted that the Refiners and Oilfield Services group should exhibit only mild spending growth. Capital discipline remains in full swing throughout the industry as companies continue to spend well below cash flow levels. Further, service cost inflation of 10% and nominal spending gains of 15% or less leaves real growth closer to 5%, rather small in the grand scheme, they said.
CreditSights' baseline cash availability projections for 2005 begin with end-of-quarter 3Q2004 cash on the balance sheet and also included any other known uses or sources of cash such as asset dispositions. "We have not included known share buyback programs, scheduled dividend increases, or scheduled or unscheduled debt reduction, as the report will progress to ultimately include these items."
For the full report, visit www.creditsights.com.