Oil & Gas Industry

The emerging positive narrative of a favorable outlook for the U.S. economy has done wonders for the markets, particularly equities and commodities. The broad equity markets as well as most commodity groups are up smartly from their early-March lows.

Crude oil’s gains have been even more impressive, given its heavy leverage to the health of the global economy. Our view is that oil should be able to hold onto its recent gains and consolidate around current levels, provided this favorable economic view remains in place.

While we have greater confidence in the staying power of the current oil rally, this does not mean that we will not see any short-term pullbacks. On the whole, we expect oil prices in 2010 to be higher than the 2009 levels, but remain significantly below the 2008 peak levels.

Crude oil’s near-term fundamentals remain dismal, to say the least. Inventories in the U.S. are at multi-year highs and remain bloated worldwide. At current projections, global 2009 demand will be below last year’s level, which itself was below the 2007 level -- the first time since the early 1980’s of two back-to-back negative growth years.

The only positive in this otherwise bleak supply-demand picture is OPEC’s success at taking a fair amount of oil off the market. OPEC’s successful stewardship provided the commodity with a floor in Dec’08 in the low $30’s a barrel range.

While the market has been heavily discounting the commodity’s near-term problems, we would expect the day-to-day price movement to largely track the news flow about the health of the global economy.

The oil price outlook has historically been the key determinant of the sector’s performance. And given our favorable oil price view, we would strongly advocate for taking an over-weight position in the sector.

OPPORTUNITIES

This outlook has major implications for sub-sector choices within the energy space, though the risk-reward trade off for most of these sub-sectors remains compelling despite recent gains.

The strengthening oil price environment should benefit producers, particularly those international players having attractive growth opportunities in their home markets. Two such standout names are Brazil’s Petrobras (PBR - Analyst Report) and China’s Cnooc Ltd. (CEO - Analyst Report). Both of these emerging market energy plays offer lucrative growth opportunities going forward. Italy’s Eni (E - Analyst Report) also remains attractive at current levels.

Petrobras is perhaps the only major oil company worldwide that has discovered substantial oil reserves in recent years. The company’s discovery of oil offshore Brazil in the massive Tupi field, expected to be developed in the coming years, has made Brazil a major oil player.

Cnooc Ltd. remains well placed to benefit from China’s growing energy appetite. The company enjoys a monopoly on exploration activities in China’s very prospective offshore region. Cnooc Ltd. also has a growing presence in China’s natural gas and LNG infrastructure.

WEAKNESSES

Despite their strong recent gains, we continue to feel strongly that industry players in the servicing and drilling ends of the business with substantial natural gas-focused and North America-centric operations should be avoided. We also remain wary of refiners, given weak gasoline demand and strengthening oil prices.

A major sub-sector that fits that description is the onshore drillers. We believe that pricing and margins for operators in these two sub-sectors will remain under pressure through 2010, even as the outlook for natural gas price improves. As such, we would avoid Nabors (NBR - Analyst Report) and Patterson-UTI (PTEN - Analyst Report), two major North American land drillers.

We continue to have a negative view of refiners as well, particularly independent refiners such as Valero (VLO - Analyst Report) and Tesoro (TSO - Analyst Report), who have no other line of business to support them in the current soft environment. The massive economy-wide job losses are not expected to reverse anytime soon even though the outlook for the overall economy has steadily improved. This, coupled with an unfavorable regulatory landscape, is expected to keep demand under pressure for the foreseeable future. Margins are expected to remain under pressure given the strengthening oil prices (oil is a refiner’s primary feedstock).