US Oil and Gas 2017: Kicking Off the Next Cycle

Deutsche Bank Markets Research North America United States Industrials Integrated Oil Industry Integrated Oils & Refining Date 3 January 2017 Recommendation Change US Oil and Gas 2017: Kicking Off the Next Cycle US Energy – Ready to Help Make America Great...Again ________________________________________________________________________________________________________________ Deutsche Bank Securities Inc. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016. Ryan Todd Research Analyst (+1) 212 250-8342 ryan.todd@db.com David Fernandez Research Associate (+1) 212 250-3191 david.fernandez@db.com Joe McKay Research Associate (+1) 212 250-5717 joseph.mckay@db.com Key Changes Company Target Price Rating APA.N 62.00 to 65.00(USD) - APC.N 77.00 to 86.00(USD) - CVX.N 120.00 to 135.00(USD) - DK.N 14.00 to 26.00(USD) - DVN.N 55.00 to 54.00(USD) - HES.N 61.00 to 58.00(USD) - HFC.N 30.00 to 38.00(USD) Hold to Buy KOS.N 12.00 to 11.00(USD) - MRO.N 21.00 to 22.00(USD) - MPC.N 54.00 to 65.00(USD) - NBL.N - Buy to Hold PSX.N 82.00 to 85.00(USD) - TSO.N 98.00 to 106.00(USD) - VLO.N - Buy to Hold XOM.N 88.00 to 95.00(USD) - Source: Deutsche Bank Top picks Anadarko Petroleum (APC.N),USD70.25 Buy ConocoPhillips (COP.N),USD50.61 Buy Devon Energy (DVN.N),USD47.08 Buy Marathon Petroleum Corp (MPC.N),USD52.93 Buy Marathon Oil (MRO.N),USD17.76 Buy Source: Deutsche Bank Heading into 2017, we view the former US Navy mantra, KISS (Keep it Simple Stupid), to be wise advice. US E&Ps are set to kick off another multi-year growth cycle, with deep, high-quality inventory, expanding margins and attractive cost structures. Risks from cost inflation and infrastructure may increase in 2H17, and valuations are at a premium vs. historicals, but we view both as manageable and remain positive the sector. In US refining, we remain relatively neutral, expecting a muddier picture, with potential regulatory tailwinds hoping to make up for a rather underwhelming macro outlook and elevated valuations. Within, we answer key questions facing investors in 2017. US E&Ps: Kicking off another multi-year growth cycle Similar to the outlook for broader US crude production, 2017 is a year of inflection, with the E&P sector set to leave behind the declines of 2014-2016 and kick off another multi-year growth cycle. We see the group in a relative sweet spot, with improved post-OPEC crude stability, a low cost structure with limited to modest cost inflation (5%-15% YoY), expanding margins, and unprecedented visibility on resource depth and growth (~23 yrs of avg. capex-weighted inventory life; 10.5% avg 3-yr oil volume CAGR at $55/bbl crude). Rising risks? Manageable, but be mindful as the year progresses With 10%-20%/yr multi-year growth rates becoming the norm across the sector, operational execution, and the ability to mitigate potential risks to the outlook are likely to become sources of differentiation amongst the group. We see three primary risks to the growth outlooks: 1) service cost inflation, 2) supply chain/infrastructure tightness and 3) commodity weakness (likely caused by overly aggressive growth). Although we see each as not particularly impactful until 2018+, we view the potential to mitigate risks via partially integrated models (EOG, PXD) or dedicated midstream relationships (DVN, APC) as a positive differentiator. We downgrade NBL from Buy to Hold on relative valuation and less leverage to crude and resource expansion drivers. US Majors – Emerging better than before FCF inflection points from the start of key long-cycle projects, deflation in an unsustainably high cost structure, and a material shift towards capital efficient, high-return short/mid-cycle projects is likely to see the first structural increase in majors’ returns profiles in years. Growth in cash return to shareholders likely remains modest in a sub-$60/bbl world though. We continue to prefer CVX to XOM on crude leverage and visibility to improving returns. US refining: High-impact, low-probability event drivers in a new administration While we expect refining fundamentals/margins to be modestly improved YoY (gasoline/distillate balances 40/120 Mbd tighter YoY), we expect shares to increasingly be driven by a variety of emerging themes, including the potential for corporate tax cuts (15%-30% potential increase to EPS), RINs relief (~15% to EBITDA), widening d