Energy & Utilities Sector Update Fall 2015 (1)

Energy & Utilities Sector Update Fall 2015

Page 1

ConocoPhillips (COP): Bought: $65.32, Target: $71.60, Last: $47.75

Overview:

ConocoPhillips (COP) is the world’s largest pure play exploration and production company. Compared to 2Q2014,

second quarter 2015 results show a loss of $179mm and that a 22.15% drop in costs from cutting and efficiencies was

overpowered by revenue decline of 41.09% from the significant drop in realized oil selling prices. The fund invested in

COP on the basis that it was trading at an 8.22% discount to its historical 10 year average EV/Daily Production multiple

due to the market selloff of energy investments, 5 year low crude oil prices, and rising US oil inventories. It was

expected that commercial cargo shipments from the Australia Pacific LNG project, cost savings in the Lower 48

resource plays, and continued funding of the 4.71% dividend would propel COP to a fair value multiple of 65.16x

EV/Daily Production.

Catalyst Update

APLNG Project Commercial Cargos

The Australia Pacific LNG project is expected to refine an annual 7.6mm metric tons of LNG for Sinopec, a Chinese oil

and gas firm, and 1mm metric tons for a Japanese utility company and was expected to come online in June 2015.

Looking forward, we see the slowdown in the Chinese economy, most recently seen in the drop in the purchasing

managers index from 50 to 49.7, as a serious concern for this catalyst’s realization.

Cost Savings in Lower 48 Resource Plays

COP projects to save $500 million during 2015 from decreased transportation, materials, and service costs and

operational efficiencies. Though production levels are on historical par, operating margins have drastically fallen from

23.54% in 2Q2014 to -1.05% in 2Q2015. It appears that oil’s decline has eliminated any effect this catalyst could have

had.

Management’s Commitment to the Dividend

COP had the highest dividend yield of all its US peer independent E&P competitors, 4.71% at pitch and 6.39% at

today’s prices. Management insists that cost cutting and curtailed CAPEX plans and cost cutting will allow COP to

reach cash flow neutrality by 2017. According to Morningstar, this goal is achievable based on $60/barrel Brent. The

heavy dividend commitment result in a LTM from June ’15 payout ratio of 132.73% and requires debt financing

Company specific news: COP Announces 10% Cut in Global Workforce

According to a September 1, 2015 article on CNBC, ConocoPhillips has announced that low oil prices are forcing it to

cut about 10% of its 18,100 person-strong global workforce. The layoffs are expected to affect about 500 of the 3,753

workers in the company’s Houston, TX headquarters. More information about the layoffs is expected in the coming

weeks.

Outlook

Management’s assertions of lowering CAPEX by $500mm and cutting operating costs by $1 billion via restructuring

should help COP’s negative cash flow situation (-$3.793 billion in 2014) but if Brent oil doesn’t average $60/barrel soon,

COP will need to further reduce CAPEX and risk a growth rate lower than 3-5%. Since inception, COP has

underperformed the energy sector ETF by -8.07%. Analysts at Thomson ONE foresee COP’s EPS at -$0.09, $1.76, and

$3.38 for 2015, 2016, and 2017, respectively. These earnings fall vastly short of 2013 and 2014 EPS of $5.70 and $5.30,

respectively. Because of COP’s underperformance compared to XLE and the meager earnings potential for the next

twelve months, we recommend selling COP.


Page 2

Valero Energy Corporation (VLO): Bought: $62.06, Target: $68.66, Last: $59.34

Overview:

Valero Energy Corporation is an independent oil and ethanol refining company that operates in the United States,

Canada, the Caribbean, the United Kingdom, and Ireland. Falling feedstock costs in 2Q2015 increased average

operating income per barrel by $4.10 (94.04%), which drove 2Q2015 operating income to rise by $993 million to a total

of $2.078 billion. Valero to beat 2Q2015 EPS estimates of $2.42 by $0.24 at $2.66 per share. The fund purchased

Valero on the basis that it was trading at a 15.09% discount to its historical 3 year average EV/EBITDA multiple due to

broad market selloffs of the energy sector and tightening WTI/Brent spread differentials. Valero was expected to

appreciate to a target EV/EBITDA multiple of 4.57x because of investments in light sweet crude oil, lower costs in the

Quebec City refinery, increased distributable cash flow from Valero Partners (VLP), and an expanding WTI & LLS

discount to Brent.

Catalyst Update

Investment in Light Sweet Crude Refining and Location

Valero is currently adding another 185Mbpd to total light sweet crude capacity, which should be complete by the first

half of 2016. Operations utilized 96% of total capacity in 2014 and 92% in 1Q2015. Since the pitch, Valero has also

planned a combined 30Mbpd expansion to two other refineries. This catalyst has not yet played out.

Enbridge Line 9B Reversal

The Canadian National Energy Board’s decision to reverse the flow of crude on Line 9B was completed in November

2014 and allowed cheaper West Canadian Crude to flow east. In its June 2015 investor update, Valero announced that

cost savings from the reversal should materialize in 3Q2015. Income per barrel should further increase as this catalyst

plays out in 3Q2015.

Accelerating Valero Partners (VLP) growth

Valero Partners beat 2Q2015 distributable cash flow (DCF) per share estimates by $0.17/unit at $0.66/unit due to

higher terminalling volumes, lower operating expenses, and lower SG&A expenses. Effective March 1, 2015, Valero

dropped down its Houston and St. Charles Terminal Services Businesses to the Valero Partners MLP. According to

Wells Fargo Securities, Valero has increased the EBITDA eligible for MLP drop-down from $814 mm to $1,164mm.

Accordingly, Wells Fargo revised its DCF per share estimates upwards for 2015 and 2016 to $2.34 and $2.88,

respectively. Barring another favorable surprise, this may be played out and priced in, as the market has raised the bar

for Valero Partners.

WTI-Brent/LLS-Brent differential Expansion

The discount that WTI and LLS trade to Brent crude, the international benchmark, gives Valero a cost advantage over

foreign competitors. In 2Q2015, WTI and LLS traded at an average discount of $5.66 and $1.60, respectively, to Brent.

The EIA projects that WTI will trade at an average discount of $5/barrel to Brent in 2015 and 2016. This catalyst seems

to have reached its zenith in 1Q2015.

Outlook:

Valero outperformed the energy sector ETF (XLE) by 11.86% since inception. Going forward, we see Valero facing

significant headwinds in the coming years because the drop in feedstock costs will be more offset by lower finished

goods prices. Additionally, demand for gasoline and other refined products is expected to curtail with the end of the

summer driving season. We recommend selling this stock due to the impending margin compression facing Valero and

similar refiners.


Page 3

EQT Corporation (EQT): Bought: $81.45, Target: $98.90, Last: $77.82

Overview:

EQT Corporation (EQT) operates in two business segments: EQT Production and EQT Midstream. Sales volume grew

by 34% but was offset by a 53% lower average realized sales price compared to 2Q2014. EQT incurred an operating loss

of -$66.9 million, including -$25.9 on hedges, compared to operating income of $144.7 million last year. The fund

invested in EQT on the basis that it was trading at a 10.26% discount to its historical 5 year average EV/EBITDA

multiple and a 19.48% discount to its historical 10 year average EV/EBITDA multiple due to the market selloff of

energy investments. It was expected that increased production growth in highly economic parts of the Marcellus Shale,

the maturation of the company’s midstream operations and the carve-out of its MLP EQT Midstream Partners (EQM),

along with service cost deflation for EQT and the company’s new Utica dry gas exploration would bring EQT to its

historical 5 and 10 year multiples of 11.33x and 10.17x, respectively.

Catalysts:

Economic Marcellus Shale and Upper Devonian Production Growth

In the second quarter 2015, EQT drilled 48 gross wells (38 located in the Marcellus wells) bringing the total to 797 wells

spud from 759 in the first quarter of 2015. This resulted in 34% higher production sales volume that was offset by 53%

lower average realized sales prices compared to last year. Although this catalyst is still playing out, low natural gas prices

have prevented it from adding value.

Maturation of Midstream Operation and EQM Carve-out

EQT Midstream’s second quarter 2015 operating income was $108.2 million, 22% higher than the second quarter of

2014. This is consistent with the growth of gathered volumes and increased capacity-based transmission revenue. This

catalyst is continuing to add value to EQT, however low natural gas prices have offset all increases in revenues.

Service Cost Deflation

Since April, EQT has reduced its cost per well by 5% and has now reduced its costs per well by 16% on the year. This

compares to their estimates of 15-20% reductions for the full year 2015. Although the company is cutting costs, the

current economic conditions of natural gas prices have prevented this catalyst from boosting share value.

Utica Dry Gas Exploration

EQT Corp. concluded its 24 hour deliverability test to sales of its first Utica well. The test revealed the well averaged

72.9 million cubic feet per day with an average flowing casing pressure of 8,641 psi. Management plans to spud and test

another well in 3Q2015 in order to test their estimates that wells in the area can be drilled at a total cost of

approximately $12.5 million for a 5,400 foot lateral. This catalyst is still playing out and has the potential to increase

revenues as EQT holds about $2 billion in cash on hand.

Company specific news: EQT misses on Q2 Earnings

EQT announced 2015 net income attributable to EQT of $5.5 million, or $0.04 per diluted share (EPS), compared to

2Q2014 earnings of $110.9 million, or $0.73 EPS. Adjusted net income for the quarter was $1.1 million, or $0.01

adjusted EPS, compared to adjusted EPS of $0.61 in 2Q2014. Adjusted operating cash flow from EQT was $80.7

million in 2Q2015; $202.3 million lower than the same period last year. This miss is attributable to lower sales prices.

Outlook:

Management increased its 2015 guidance for production sales volume to 595-605 Bcfe, including liquids volume of 9,000

10,000 MBBls. 3Q2015 volume is estimated at 150 155 Bcfe, with liquids of 2,300-2,400 MBBls. The Company also

expects the average differential to the NYMEX (NMX) price forecast of -$0.35 to -$0.45 per Mcf for 2015; with an

average differential to the NYMEX price of -$0.85 negative $0.95 per Mcf for the 3Q2015. Since inception, EQT has

outperformed the energy sector ETF by 10.8%. Analysts at Thomson ONE foresee EQT’s EPS at $1.17, $1.44, and

$2.56 for 2015, 2016 and 2017, respectively. Due to EQT’s solid balance sheet, outperformance compared to XLE, and

cost reduction measures, we recommend holding EQT.


Page 4

Schlumberger Limited (SLB): Bought: $92.16, Target: $115.16, Last: $77.37

Overview:

Schlumberger N.V. (SLB) is a supplier of technology, integrated project management, and information solutions to the

international oil and gas exploration and production industry. The Company operates in the oilfield service markets

through three Groups, which include Reservoir Characterization Group, Drilling Group, and Production Group.

Compared to 2Q2014, 2Q2015 results show revenues decreased by 12% to $9 billion. This resulted in detrimental

margins of 23%, however the company generated $2.3 billion of cash flow from operations. The fund purchased SLB

on the basis that it was trading at an 8.5% discount to its “implied average” EV/EBITDA multiple due to broad market

selloffs of the energy market and commodity prices expecting to stay flat through 2014. SLB was expected to appreciate

to a target EV/EBITDA multiple of 11.15x as more international oil E&P’s grew capital expenditures, the Asian natural

gas market grew and new products including its HiWay fracturing equipment and StethoScope technology increased

revenues and earnings.

Catalysts:

Middle Eastern and Latin American oil companies expected to raise exploration and production spending by 14% in 2014

The recent oversupply in the energy sector has caused exploration and production spending to decrease for most of

2015 which contributed to SLB revenues decreasing by 12% to $9.0 billion in 2Q2015. The company saw revenue in

Latin America decline by 7% and 5% in the Middle East and Asia in the quarter. With the current volatility in oil prices,

we do not foresee this catalyst playing out within our investing time frame.

Expected production increases in China.

Schlumberger’s international markets (including Middle East and Asia) revenue declined by 5% sequentially driven by

further budget cuts from the company’s customers as well as further pricing concession. For the first half of the year,

revenue has now dropped 14% compared to last year. With the economic slowdown in China and the global supply pile-

up, we do not see this as a current catalyst.

New Products

EQT is still in the process of integrated their new technologies and have set a target of a 10-fold reduction in customer

non-productive time, a doubling in asset utilization, a 25% reduction in inventory days, a 20% increase in workforce

productivity and a 10% lowering of unit support costs. This catalyst will add value to the company once the technologies

are fully integrated.

Company specific news: SLB acquires Cameron International Corp. (CAM)

SLB announced in August its plan to acquire Cameron International Corp. (CAM) for $12.7 billion in cash and stocks, a

56.3% premium to CAM’s stock price on August 26th, 2015. Schlumberger expects pretax synergies of about $300

million in the first year and $600 million in the second year after the deal closes. The transaction will add to per-share

profit by the end of 2016, Schlumberger said.

Outlook:

Management expects an extended volatile oil market as it forecasts E&P investments in North America to be down 35%

in 2015 and 15% in international markets. Analysts at Thomson ONE expect EPS to be $3.55, $3.75 and $4.77 in years

ending 2015, 2016 and 2017 respectively. With Schlumberger’s ability to generate cash, its market size and its

outperformance of XLE by 11.26% in a volatile energy sector warrants a hold recommendation from us.


Page 5

Appendix

COP vs XLE

2013 2014 2015E 2016E 2017E

Revenue ($mm) 58,248 55,054 36,054 47,605 58,646

Gross Margin (%) 44.15 28.69 34.64 39.10

Earnings Per Share ($) 5.70 5.30 -0.09 1.76 3.38

ConocoPhillips Forecast


Page 6

VLO vs XLE

2013 2014 2015E 2016E 2017E

Revenue ($mm) 138,074 130,844 85,649 90,331 99,427

Gross Margin (%) 6.73 9.71 14.45 10.69 7.88

Earnings Per Share ($) 4.49 6.68 8.36 6.64 7.80

Valero Forecast


Page 7

EQT vs. XLE

2013 2014 2015E 2016E 2017E

Revenue ($mm) 1,713 2,267 2,181 2,594 3,092

Gross Margin (%) 63.81 91.81 85.53 87.15 75.71


EQT Forecast


Page 8

SLB vs XLE

2013 2014 2015E 2016E 2017E

Revenue ($mm) 45,266 48,580 36,618 37,546 42,184

Gross Margin (%) 22.28 23.02 26.19 25.96 28.59


Schlumberger Forecast

Documents

Energy & Utilities Sector Update Fall 2015 (1)