Morgan Stanley: Oil, gas fundamentals remain supportive despite pullback

Macro uncertainty has weighed on oil and exploration and production (E&P) companies in recent weeks, but the underlying fundamentals remain supportive, according to a Morgan Stanley analysis.

Since the end of June, E&Ps and oil (stocks) have fallen by about 20% and 15%, respectively, as the market has become increasingly concerned about refined product demand amid resurging COVID-19 cases globally. On a macro level, Fed minutes recently showed an emerging consensus to begin scaling back asset purchases this year, reducing interest in energy as a reflation trade, while a stronger dollar has also weighed on oil prices.

“While heightened volatility is likely here to stay until Delta variant concerns start to moderate (or global case counts start to show positive rate of change), we see a growing mismatch between the sector’s performance and underlying energy market fundamentals, which remain constructive in 2021 second half,” Morgan Stanley wrote in a report.

“Total oil inventories have continued to draw and now sit near 5-year lows, capital discipline is holding within US shale (limiting supply growth), and Morgan Stanley oil strategist Martijn Rats expects OPEC+ to remain supportive of market prices. As a result, we see the recent pullback as an attractive entry point to add selective E&P exposure.”

Meantime, Morgan Stanley believes that the Delta wave peak in the US may be approaching. “Based on the reproduction rate trajectory, US/UK hospitalization relationship, and previous peaks, Morgan Stanley’s Biotech analyst Matthew Harrison expects the current wave in the US to start to decline in late August or early September. If the UK is any indication, mobility data (and gasoline demand) in the US is likely to rebound following the peak in infections. In China, the second largest oil consumer after the US, COVID-19 cases have also begun to roll over in recent days.”

Key themes in second-half 2021

“While soft spots have emerged in the oil demand recovery and macro outlook, oil market fundamentals remain intact with GDP growth likely still on track, steady inventory draws, a sizeable deficit expected for second-half 2021, and OPEC likely to manage prices through 2022. Altogether, this supports our oil strategist’s view of mid-to-high $70/bbl Brent in a supply-constrained environment and we expect demand to recover as COVID-19 cases decline,” the report said.

“For natural gas, tight inventories, and warmer weather (increasing power burn) have driven Henry Hub for the balance of 2021 to around $3.90/MMbtu, slightly above our current estimate of $3.60/MMbtu. Low inventories, strong exports to Mexico, industrial demand growth, and lower hydropower generation in the Western US due to below normal reservoir levels should be supportive of prices in the back half of 2021.

“Capital discipline holding, efficiencies offsetting cost inflation. Through the second quarter earnings season, none of the companies in our coverage increased 2021 organic D&C budgets (beyond changes related to acquisitions), demonstrating continued spending discipline despite higher commodity prices. Meanwhile, moderate cost inflation across steel, labor, and fuel costs has been largely offset by increased D&C efficiencies. We expect this trend to continue, with many producers highlighting the ability to lock in spending on certain categories such as rigs and tubulars at the start of the year. Looking ahead into 2022, we do expect moderate degradation in capital efficiency for our US-focused coverage, though not enough to derail the sector’s FCF story. Our estimates currently reflect an average of 5% inflation in 2022, and a similar amount in 2023.

“Excess cash flow is increasingly being directed towards debt reduction and shareholder returns. In recent months, boosting or accelerating cash returns has been a key driver of outperformance. With second quarter earnings, E&Ps continued the trend from first quarter results, holding spending flat and directing excess cash flow towards shareholder returns and debt repayment. Notably, several companies have announced increases to base dividends and or variable/special dividends.

“The focus of strategic action and M&A has largely been on asset-level M&A through sales of non-core acreage or bolt-on acquisitions. However, with second quarter results, we saw some larger corporate deals. Going forward, we expect commodity prices to support a market for continued non-core asset sales as companies optimize their portfolios and accelerate deleveraging. For those with the willingness and capacity, Public-Private consolidation remains an opportunity to increase scale and efficiencies,” the report concluded.