The Box of Chocolates Called Earnings

Earnings season is upon us, and so far the trends are much as we expected. In this issue of The Energy Letter, I will discuss how these trends have affected various sectors in the oil and gas industry, and take a look at the earnings of some companies from these sectors.

As we have warned since January, the price spread between Brent crude and West Texas Intermediate (WTI) was likely to narrow this year from 2012’s lofty levels, and that would affect many companies in the oil and gas sector. The dynamic between the price of WTI and Brent largely explains the second-quarter results across the oil and gas sector.

Brent prices fell nearly $10 per barrel during the quarter, and the Brent-WTI price differential shrank substantially. The falling differential spells trouble for refiners and railroads, but is good news for pipeline companies. That the differential declined because of sharply lower Brent prices was bad news for major integrated oil producers with substantial international crude oil production operations, but the continued strength in the price of WTI was great news for domestic producers. Finally, the continued recovery in natural gas prices was very good news for natural gas producers in the US.

commodity prices chart
Domestic oil producers had quarters ranging from good to great. EOG Resources (NYSE: EOG) had a great quarter. EOG is the largest oil producer in the Eagle Ford formation in Texas as well as one of the top five oil and gas producers in the Bakken. EOG is by far the largest horizontal crude oil producer in the US, with nearly 200,000 barrels per day (bpd) of crude oil produced by horizontal drilling at the end of 2012.

EOG’s second-quarter profit rose 67 percent to $2.10 a share, beating consensus estimates by 21 percent. As a result of the strong quarter, several firms upgraded the stock. In the latest period, EOG’s crude oil and condensate revenue grew by 46 percent. But the company isn’t merely benefiting from strong prices. EOG raised its crude oil production growth target for the year from 28 percent to 35 percent, and raised its overall production growth target from 4 percent to 7.5 percent.

For refiners like Valero (NYSE: VLO), the shrinking Brent-WTI differential was very unwelcome news. Valero posted diluted earnings per share of $0.85 on revenues of $34 billion, falling 4.3 percent short of recently lowered consensus earnings estimates. In the second quarter of 2012 Valero had posted earnings of $1.50 per share on revenues of $34.66 billion.

The single biggest factor behind the earnings plunge was the sharply lower Brent-WTI differential (refiners with mid-continent operations had previously made a lot of money buying crude at WTI prices and selling fuel at prices tied to Brent), but the cost of complying with federal ethanol mandates also took a bite out of profit margins. (In this week’s issue of The Energy Strategist, I will discuss the EPA’s recent announcement to roll back some of the mandates, and speculate whether the worst has passed for the refiners.)

The shrinking differentials will also affect the profits of railroad companies that have been doing a brisk business in moving crude from the Midwest to coastal refineries. While second-quarter earnings of railroad companies like Union Pacific (NYSE: UNP) were largely in line with expectations, you can expect a softer third quarter at current differentials. In fact, I have friends who work for the railroad industry in North Dakota and they have advised me that crude oil bookings are sharply down in August.  

The railroads’ loss will be pipeline companies’ gain, as they will be the preferred method of transport with differentials under $10/bbl. Master limited partnerships like Plains All American Pipeline LP (NYSE: PAA) saw profits take a hit in the second quarter as competition from railroads cut into their logistics business. PAA’s profits were down 23 percent over the same period last year. But expect them to bounce back this quarter based on the current Brent-WTI differential.  

Major integrated oil companies like ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) were dragged down for two reasons. The aforementioned problems with the refining sector hit their downstream (i.e., refining) businesses, while lower Brent prices hit their international upstream (i.e., oil and gas production) businesses. Chevron’s profit declined 26 percent over Q2 2012. Its downstream profit fell 59 percent and the upstream profit fell 12 percent year-over-year. XOM reported a year-over-year decline of 19 percent (after excluding a one-time gain in 2012 of the sale of its Japanese lubricants division).

Natural gas prices have made a strong recovery from 2012’s lows, and natural gas producers like Chesapeake (NYSE: CHK) are reaping the benefits. CHK reported adjusted second quarter 2013 earnings of 51 cents per share beating consensus estimates of 39 cents per share. Earnings a year earlier had been only 6 cents per share. Higher natural gas prices were one factor, but the company has also been putting more effort into producing oil, and has been rewarded with higher margins.

In this week’s issue of The Energy Strategist, we will discuss the picture for the rest of 2013.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Don’t Stop Buying EOG

Robert has already summarized EOG’s exceptionally strong results, driven by its excellent positions in the sweetest spots of the best-performing shale plays as well as industry-leading well completion technology. I’ll just apologize for being too conservative when we placed a $145 price target on the stock in March.

Great companies outperform investors’ most optimistic expectations and this has certainly been one of these, as shares have appreciated 135 percent since they were added to the portfolio four years ago and nearly 40 percent in not quite four months. And they’re not done considering that EOG now has three separate resource plays where it can double its investment on an after-tax basis within the year, and will have ample free cash-flow to make such investments over the next year and beyond. We’re raising the buy below target to $180, because EOG remains the very definition of a best buy.  

— Igor Greenwald

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