All's Well for Oil and Gas

With stock-price momentum recovering and industry fundamentals favorable, S&P says exploration and production companies may have further upside

by Sam Stovall From Standard & Poor's Equity Research

52-Week Relative Strength: Oil & Gas Exploration & Production

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The S&P 1500 Oil & Gas Exploration & Production subindustry index has moved up two relative strength ranking (RSR) levels in the past 13 weeks and now sports an RSR of 3, indicating that its trailing 12-month price performance is now in the middle 40% of all 136 subindustry indexes in the S&P 1500. Year to date through May 18, the S&P Oil & Gas Exploration & Production Index jumped 18.3%, vs. a 7.7% gain for the S&P 1500. In the past 13 weeks, this sub-industry index gained 15.2%, to the market's climb of 4.5%.

Take a look at the accompanying chart of this subindustry index's rolling 12-month price performance compared with that for the S&P 1500. Any point above 100 indicates sector outperformance vs. the S&P 1500 over the prior year, while points below 100 show sector underperformance. The red line is a rolling nine-month moving average, while the two green bands indicate one standard deviation above and below the index's longer-term mean relative strength.

There are 24 large, mid- and small-cap companies in the S&P Oil & Gas Exploration & Production subindustry index. Of those, four carry strong buy recommendations: Chesapeake Energy (CHK), Cimarex Energy (XEC), EOG Resources (EOG), and Swift Energy (SFY).

Roll Out the Barrels

Michael Kay, who covers the group for S&P, says that with its emphasis on the North American onshore natural gas producers, S&P's fundamental outlook for the oil & gas E&P subindustry for the next 12 months is positive. His view reflects a tight market characterized by scant spare capacity still vulnerable to disruptions from significant supply sources (e.g., the Middle East, Russia, and Nigeria).

However, while Kay believes that these markets have created slightly more idle capacity by virtue of lower worldwide demand expectations and historically high seasonal natural gas storage levels, he also thinks current natural gas prices continue to provide attractive valuations for onshore North American natural gas producers.

The International Energy Agency's 2007 global demand growth projection is 1.5 million barrels per day, or 1.7%, reflecting mild weather in North America and the removal of consumer subsidies in Southeast Asia. U.S. gross domestic product rose 2.2% in the fourth quarter of 2006, up from the third quarter's 2% pace. In S&P's view, demand drove the historic energy bull market over the past three years, vs. supply disruptions in previous bull markets, and Kay thinks a demand-driven response will end this bull market cycle. While S&P believes we're seeing the beginnings of that demand response, it thinks oil prices above $60 per barrel are supportable through 2007.

S&P's price forecasts, as provided by Global Insight, are for full-year 2007 natural gas prices to rise 3.6% from 2006 levels (8% decline for oil), and increase further by 10.8% in 2008 (1.1% increase for oil), as local North American natural gas fundamentals return to normal. Consequently, Kay believes the continued high price environment will help natural gas producers absorb double-digit service cost inflation and thus achieve superior returns on capital vs. E&P companies with more exposure to oil. Given these sector dynamics, Kay would emphasize companies that have an abundance of undeveloped land and multi-year natural gas project inventories.

So there you have it. The group's longer-term momentum is recovering, and its overall fundamental outlook is positive, indicating that from fundamental and momentum perspectives, this subindustry index may continue to see strong price performances in the period ahead.