Integrated OilRefiners:4Q Upstream Earnings,Managing the Upswing

A bird in hand or two in 2H17

    With most of our upstream coverage having reported, we see two emergingthemes: 1) L48 volume growth will be sluggish in 1H17 (1Q17 L48 guides -2.5% vs. DBe), though with a higher exit rate/trajectory into 2018 (implied4Q17 vols +3% vs. prior) and 2) operating costs have bottomed. We see theL48 volume trajectory steepening into YE as efficiency gains and productivityenhancements emerge, likely raising 2018 estimates. Broadly flat LOE guidesy/y are largely reliant in 2H17 volume ramps, amid a backdrop of higher inputcosts (nat gas, labor).

    Good things come to those who wait

    Consistent with what we have been highlighting, 4Q16 results and 1Q17guides for L48 oil production have underwhelmed (missed DBe 0.5%/2.5%respectively on aggregate reporters to date) despite a rig count up 60% q/q forthose who have reported. While lower actual volumes in 1H17 willcomplement a coordinated OPEC production cut (and lend further pricesupport), FY17 guides however have been more inline, implying a steeper thanexpected ramp in 2H17 (implied 4Q17 vols. +3% vs. DBe prior estimates). Withimpacts of rig ramps not expected to be fully felt until 2H17, and a continuedupward bias from efficiency gains and productivity enhancements, we see theramp into 2018 providing growth in the aggregate of 20%-25%, which wouldimply aggregate US volume growth pushing 1.0 mmbbl/d.

    With costs having bottomed, managing the way up comes in focus

    If 3Q results showed us that most of the “low-hanging fruit” had been pickedas it relates to cost minimization, 4Q16 LOE results (+0.5% vs. DBe) and 1Q17guides (+5% vs. DBe) are showing us that maintaining low costs will not comeas easily. While acknowledging the 4Q/1Q results/guides likely reflect theimpact of a few transient issues (winter weather, fewer barrels over which tospread costs), we nonetheless see upward pressure on both operating andcapital costs moving into 2H17. Capital cost increases continue to be expected10%-15%, though are likely halfway between there and the ~30% serviceproviders are expecting. However, spot prices for natural gas (one of thebiggest LOE inputs) is up 60% 1Q17 vs. 1Q16, and while labor (the other majorLOE input) is likely a bit stickier in the near-term, with 4Q17 L48 oil volumesexpected up >20% vs. 1Q17, we see the market tightening in 2H17. We viewbroadly flat FY17 LOE guides as increasingly dependent upon achieving scale,and continue to prefer more vertically integrated names EOG, PXD, APC, DVN.

    Valuation and Risk

    Companies in our integrated/large-cap space are valued on either on aEV/DACF multiple (CVX, XOM, COP, OXY) or on a blended NAV, EV/DACFmultiple methodology. NAVs assume $65/$62 bbl and $3.30/mcf for Brent/WTI and HH pricing. Primary downside risks include a decline in global oildemand and/or price. Upside risks include increased demand and operatorefficiency. Companies in our refining coverage are mostly valued under a 2017multiple-based (EV/EBITDA) SOTP valuation. We find the refiners trading at a4.5x/2.3x consolidated/refining-only 2017 EV/EBITDA multiple, below thehistorical multiple of 4.0-4.5x (consolidated). Upside risks include wideningcrude differentials, gasoline inventory draws while key downside risk is a wanein demand.