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Global energy stocks have surged - but still undervalued: Morningstar view

Dave Sekera, CFA  |  25 Oct 2021Text size  Decrease  Increase  |  
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Energy stocks have skyrocketed this year. The Morningstar US Energy Index has jumped more than 58% for the year to date, with 15% growth in the past month alone. Yet we still see the sector as undervalued.

Our view isn’t predicated on these higher prices, but we think the market is underestimating the amount of demand for oil over the medium term. We see global oil demand at the high end of market consensus through 2030 and potentially even longer. But our view on the increased need for oil isn’t based on a dour outlook for electric vehicles, in fact, it’s just the opposite.

Oil Demand Forecast

Source: Morningstar. Data as of Oct. 12, 2021.

Within our long-term global oil demand forecasts, we incorporate our projections for the structural transition to electric vehicles away from internal combustion engines. In June 2021, we boosted our projections for EVs as a percent of global auto sales to 30% by 2030, much higher than the market’s consensus forecast.

Battery EV Share of Global Auto Sales

Our oil demand forecast is driven by a combination of the internal combustion engines that continue to be produced, their longer-lasting lifecycle, and our forecasts for an increase in miles driven over our projection period. Offsetting the future growth in EVs as a percentage of new auto sales, we take into account the fact that EVs were only about 3% of the global market share in 2020 and that autos made today may last 15 years or more.

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EVs and hybrids will reach two-thirds of new-auto sales by 2030

EV market forecast

Why have energy prices surged?

We expect tight supply and high prices in the oil market through 2022, largely owing to the underperformance of OPEC+ production as compared with its stated targets, combined with demand recovery as global economies normalise. While OPEC has announced that it intends to return to its reference levels of production by the end of 2022, we are concerned that it may have a tough time reaching that production level by then.

Although oil prices have surged, we have maintained our midcycle oil price forecasts of $55 per barrel for West Texas Intermediate and $60 per barrel for Brent. There are several reasons we think the current upward pressure on oil prices will be alleviated over time.

  • We assume that the sanctions on Iranian oil exports will be modified or lifted eventually, providing a significant amount of supply to the global markets.
  • We also expect that with additional capital spending on new and existing projects, OPEC will be able to build its production levels back up over time.
  • While US oil producers have maintained their capital discipline in the near term in balancing developing new projects versus providing higher returns to shareholders, their current plans to grow at low-single-digit rates will bring enough new supply to keep the market balanced after 2022.

West Texas Intermedia and Brent Oil Historical Prices

Source: Morningstar. Data as of Oct. 12, 2021.

High natural gas prices in Europe are the result of a confluence of factors. Europe is in the midst of an energy transition toward renewables and closing coal-fired plants, which has the effect of increasing the percentage of electricity produced by natural gas. Following a cold winter in Europe last year, inventory levels were depleted.

Typically, inventories are replenished over the course of the summer, but production remains affected by the pandemic. Also, lower wind speeds this year resulted in less wind generated power, requiring more natural gas generation to make up the deficit. Inventory levels are below where they typically are for this time of year. Electricity producers are trying to buy natural gas now in order to make up the inventory deficit before winter is in full swing.

Natural Gas and LNG Prices

Source: Morningstar. Data as of Oct. 12, 2021.

Unfortunately, there is not a lot of excess natural gas supply readily available. Norway is increasing supply to Europe, but volumes remain marginal. Russia has signaled a willingness to increase supply but offered no specifics. In addition, in the LNG spot markets, Europe has to compete with Asian buyers, such as China, who are more willing to pay high prices. China has also been making its first steps to rely less on coal-fired electricity generation while reducing its production of coal and relying more on natural gas as well. Finally, US LNG exporters are already very near capacity and unable to provide much more near-term supply until additional infrastructure is added to US facilities.

The electricity market transition from hydrocarbons to renewables is likely to lead to greater variability in power generation. Intermittency remains an issue for renewables while there is no affordable, abundant form of storage. As a result, natural gas power generation will remain the fallback supply. This means LNG ends up being the “battery” for renewables given its ability to be moved and traded globally, filling gaps where need be.

What stocks are still undervalued?

There remains a lot of negative sentiment surrounding investing in oil companies, as many investors are hesitant to invest in a commodity where the long-term trend in demand is lower. Other investors with specific environmental, social, and governance investment guidelines are unwilling to invest in firms that directly contribute to carbon dioxide emissions.

Many oil producers’ stocks have surged and several that were rated 4-stars have moved into 3-star territory. Based on our long-term forecasts for oil prices and demand, we continue to view many of these stocks as undervalued.

Exploration and Production

Data as of Oct. 15, 2021.

The oil-services sector has been especially hard-hit since the beginning of 2020. New drilling activity dropped precipitously during the early months of the pandemic.

In the United States, oil producers have taken a more measured approach to conducting new drilling activity, and the rig count has recovered back to 2018 levels only. We expect the rig count will climb around 10% in 2022.

Uncertainty levels in the services sector generally run high, but for investors who are willing to take greater risk, we see opportunities that are trading at significant margins of safety from our intrinsic valuations.

Services

Data as of Oct. 15, 2021.

For investors looking for a combination of high dividend yields and undervaluation, the pipeline sector has several to choose from. However, investors need to understand that the price movement on these stocks may be more muted in the near term.

Higher oil and gas prices benefit exploration and production companies more directly via near-term unhedged exposure and higher expected cash flows from future drilling activity.

Midstream firms and partnerships generally hedge commodity exposure to fairly minimal levels, and higher oil and gas prices don’t provide much of a direct benefit.

For pipeline companies, volumes are more important than prices, and with many US producers pledging to hold volumes relatively flat and live within cash flows in the short term, pipelines aren’t necessarily seeing the same expected volume uplift in the near term than they would have in cycles past. The key earnings driver will be growth capital spending in order to build pipelines and infrastructure to match where new gas drilling will occur with those storage facilities utilized to hold and market oil and natural gas.

Pipelines

Data as of Oct. 15, 2021.

In a market that we consider to be broadly trading on the high side of our fair value range, the energy sector is one of the few areas we continue to view as undervalued. While the undervaluation has declined as the stocks have ramped higher over the past few weeks, we continue to see more 4- and 5-star stocks in this sector than any other.

is chief U.S. market strategist for Morningstar.

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