The next two weeks will be busy in the energy sector, with dozens of upstream, midstream, downstream, and oilfield services companies reporting 1Q2012 results, as well as their outlooks for the rest of the year. The macro backdrop for the quarter is muddled – Brent crude averaged $118.70/bbl in the quarter, +13% YoY and +9% QoQ; NYMEX natural gas averaged $2.50/Mcf, -40% YoY and -28% QoQ; rig count growth slowed in North America to +12% YoY (vs. +19% YoY in 4Q11); and worldwide rig count growth slowed to +9% YoY (vs. +15% YoY in 4Q11). Our proprietary US E&P inflation index shows that costs for producers were +8.1% YoY in 1Q12, the lowest level of inflation since 4Q10.
Given those trends, we expect the oil-weighted E&Ps to deliver strong 1Q12 numbers and have positive outlooks on the rest of 2012; that is the only sub-sector we are interested in on the long side at this point. Our overall view on the energy sector is negative, primarily because we are bearish on global growth and oil prices. Brent crude has snapped TRADE line support, and we see further downside risk in one of the most-consensus commodity longs. Should oil prices continue lower, there will be little in the way of macro tailwinds to take the energy sector higher. That has started to play out with energy (XLE) down 8% over the last month, the worst performing sector in the S&P500. The XLE is also the only sector that is bearish TRADE and TREND on our quantitative model, with resistance at $70.03 and $72.11, respectively.
Below is our outlook for what we think will be the three most interesting sectors to play this earnings season: oil-weighted E&Ps, natural gas-weighted E&Ps, and oilfield services.
Oil-weighted E&Ps: Oil prices hanging in +$100/bbl coupled with cost pressures finally starting to ease is a recipe for margin expansion for the oil-weighted E&P group. We expect rigs and equipment to continue to move out of gas plays like the Haynesville, Barnett, and Woodford shales, and into oil/liquids plays like the Eagle Ford, Permian, and Cana; the additional capacity in those plays will lead to lower cost inflation. In terms of production growth, we expect big 1Q12 numbers and 2012 guidance from the group, particularly from those with production focused in the Eagle Ford and Bakken, where producers are moving from exploration to more efficient development drilling. A non-consensus way to play this consensus sub-sector long is via SM Energy (SM).
Gas-weighted E&Ps: NYMEX gas averaged $2.50/Mcf in 1Q12 and is hitting new lows today at $1.90/Mcf; there may not be a dry gas play in North America that is EPS breakeven at the current prices. While the dry gas E&Ps have gotten beat up recently (KWK and UPL are down 40% YTD), we think that there is more to come, as consensus estimates and current multiples do not reflect even strip pricing. Look for gas-weighted E&Ps to slash 2012 capex budgets and production guidance, especially those that have little liquids exposure in their production mix – SWN, UPL, and ECA are on the top of that list.
Oilfield Services: Halliburton (HAL) kicked off the earnings season yesterday with a better-than-awful quarter and outlook, though concluded the conference call with this reply to a question on what could go wrong this year, “I would say the biggest single risk [to hitting forecasted margins] probably is more around ensuring – well, I'd say, not that we can ensure it, but it's more around the continued expected progression of rig count through the balance of the year than any other factor. It looks good right now, but we have been disappointed before by the amount of growth.” In other words, macro matters more than anything else to HAL (and the OFS industry in general). We are negative on global growth and oil prices, and think that rig count trends lower over 2012. While many argue that these names look “cheap,” the most cyclical subsector in energy always looks cheap at the top of a cycle. Stay away from this group, particularly small cap pressure pumpers and land drillers.