Morningstar's Energy Favorites

05/12/2015 9:00 am EST

Focus: STOCKS

Oil prices are likely to rebound from current levels, but robust US supply will ultimately cap upside, explains the energy team of analysts at Morningstar StockInvestor.

Shale oil has effectively made the United States the world’s newest swing producer because of the scale of the resource and the ability to quickly increase or decrease production.

Drastic cuts to capital expenditures will lead to a meaningful drop in near-term production, but the strong economics of the major US liquids plays should enable volume growth to resume as soon as oil prices recover.

Futures prices indicate that West Texas Intermediate crude oil will settle at $60–$65 per barrel. These price levels provide sufficient incentive to encourage renewed investment, which in turn should lead to the resumption of production growth.

In our view, the current situation of high costs and low oil prices is not sustainable, and we expect a combination of falling costs and rising prices to provide relief in the coming years.

Among oil-focused exploration and production firms, we look for companies that are both undervalued and possess cost-advantaged assets.

Growth at Encana (ECA) is underpinned by high-quality Permian and Eagle Ford acreage and the firm also has a rock-solid balance sheet.

We also like Permian-focused Laredo Petroleum (LPI), which is trading at attractive levels that don’t account for its high-quality acreage.

We view Exxon Mobil (XOM) as offering the best combination of value, quality, and defensiveness among oil majors. BP (BP) is our favorite among the high-yield but lower-quality European integrated firms.

Our top pick among services providers is Halliburton (HAL) because of its existing exposure to North America and pending merger with Baker Hughes.

One unknown is whether the combined firm will be forced to sell off portions of its business for antitrust reasons; we discount the value of the merger by 40% to account for this risk. 

Midstream is the clear winner of our more bullish outlook for US production. Predominantly fee-based cash flows insulate midstream firms from commodity price fluctuations.

This secures the midstream growth story for several more years, providing greater visibility to investment opportunities after the current slate of projects enter service.

Spectra Energy (SE) and Spectra Energy Partners (SEP) are our top midstream picks, supported by $7.5 billion worth of projects through 2019 primarily focused on providing takeaway capacity for the Marcellus Shale.

Magellan Midstream Partners (MMP) is our favorite oil-focused master limited partnership given its robust distribution growth, excess distribution coverage, and solid portfolio of growth projects. Magellan is one of the more conservatively run MLPs and a potential refuge for risk-averse energy investors.

Despite our forecast for narrower North American differentials, we still hold a positive view of the domestic refining industry, since its feedstock cost advantage remains intact.

Within our refining coverage, we see Tesoro (TSO) and Phillips 66 (PSX) as fundamentally well-positioned and undervalued.

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