Citing lower estimates for oil and natural gas prices going into 2007, Banc of America Securities last week cut its rating on the exploration and production (E&P) sector to “market weight” from “overweight.” Assuming normal weather, the 2007 consensus estimates for oil and gas are “unlikely” to rise in the near term, energy analyst Robert Morris said in a note to clients.
Any near-term increase in consensus crude oil or natural gas prices will be driven by events such as a colder-than-normal winter or a sharp escalation in geopolitical tensions, Morris wrote. All-time seasonal highs for U.S. distillate inventories and gas storage point to “greater downside than upside risk” to consensus commodity price expectations through 2007, especially if the coming winter is warmer-than-normal.
Unless there are major project delays or unanticipated supply disruptions, OPEC will have to reduce oil production in 2007 to keep prices near $60/bbl, “which calls into question any material upside to the 2007 consensus of $61.70 per barrel at this juncture,” the analyst said.
“The outlook for oil prices in 2007 largely hinges on OPEC’s ability to cut output, which, in turn, will be a primary diver for natural gas prices.”
Merrill Lynch & Co. and RBC Dominion Securities Inc. analysts were no more enthusiastic about the energy sector and near-term prices.
Merrill’s Brian Belski downgraded the energy sector to “underweight” last week. Belski said he expects the energy sector will underperform the overall stock market in the coming months.
In a note to clients, RBC’s Angela Guo wrote, “In light of further risks to gas prices, exploration and production spending, and pressures on service pricing and margins created by potentially lower activity levels and more capacity, defensiveness and caution should continue to be the main theme over the next six-to-nine months.” Some energy stocks may look like good buys, but there is a “lack of near-term positive catalysts and continued uncertainty” on earnings that will likely depress the sector.
“As a dramatic measure of maximum risks — should the oil price fall significantly due to macroeconomic reasons, while the gas price dips further due to a warm winter, applying the historical trough trailing multiples to the stocks would imply an average downside of 24% for the sector from current levels,” Guo said.
Banc of America’s Morris also wrote last week that E&Ps using full-cost accounting methods could be facing sizable third quarter write-downs because of lower natural gas prices. He said quarterly earnings may be lower regardless because of lower prices compared with a year ago — but those relying on spot gas prices to calculate quarterly earnings may take the biggest hit.
“With natural gas prices ending the third quarter near four-year lows (composite spot natural gas price of $3.85/MMBtu, including $3.28/MMBtu in the Rockies), we expect some companies could report a one-time, noncash, ceiling test write-down or impairment charge when they report third quarter results,” Morris wrote.
The Securities and Exchange Commission regulates how E&Ps value their reserves for accounting purposes. Some producers use successful-efforts accounting, which values reserves using a mid-cycle price that covers the entire year. It also does not allow E&Ps to include hedging on their balance sheet.
Full-cost accounting, which allows E&Ps to use swaps and basis hedges for valuing future cash flow, marks the predicted value of reserves at end-of-quarter spot prices. If the reserves value is lower, E&Ps are required to take noncash write-downs to reduce the value of the reserves on the balance sheet for that quarter.
Morris noted the one-time charges under full-cost accounting methods would not impact the worth of the proven reserves “or even the quantity of the reserves…just the carrying value of the proven reserves on their books.”
“Ceiling impairment tests are based on a lot of detailed data, most of which is not publicly disclosed, and thus it is difficult to project which companies are likely to take ceiling/impairment test write-downs,” Morris noted. Other “key variables” also could affect write-downs — including the geographic location of the reserves. Rocky Mountain producers may be at higher risk for write-downs in the quarter if they use full-cost accounting because prices in the Rockies are consistently lower than in other U.S. basins.
Even without Rockies exposure, Morris said E&Ps could see lower earnings in the quarter if they have high gas-to-oil ratios, where oil production can’t offset weak gas prices. Morris cut the ratings on seven E&P stocks Banc of America covers to “neutral” from “buy” and reduced their price targets. He said the ratings downgrade on some E&Ps reflect expected downward earnings adjustments for both 3Q and 4Q2006 earnings and cash flow per share estimates.
“Attractive” valuations for E&Ps will not be enough to drive “out performance” in the current environment if consensus estimates also are not rising, Morris noted. E&Ps most at risk in the event of a drop in Wall Street consensus estimates for commodity prices are Anadarko Petroleum Corp., Noble Energy Inc., Comstock Resources Inc., Cabot Oil & Gas Corp., Houston Exploration Co., Whiting Petroleum Corp. and Talisman Energy Inc.
Banc of America kept a “buy” rating on Apache Corp., Chesapeake Energy Corp., Devon Energy Corp., EOG Resources Inc., Southwestern Energy Co. and XTO Energy Inc.
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