We're raising our fair value estimate for Murphy Oil to $34 from $33 after taking a second look at the firm's third-quarter financial and operating results. That leaves shares looking rich at the current level, consistent with other exploration and production, or E&P stocks. Broadly, we think the market is extrapolating the current and very favorable oil price environment too far into the future. To get our model to match the market price we'd have to raise our midcycle forecast for WTI crude to about $65/bbl from $55/bbl, even though the marginal supply cost is unlikely to be that high.

As we discussed at the time, shares slumped when the firm reported its third-quarter results on Nov. 3, and the selloff has continued since then alongside the dip in crude and natural gas prices. We suspect investors balked at the downward revision to the full-year outlook for production coupled with an 8% increase in the annual budget (which is a huge uptick given 10 months of the year are already in the bag). Management also highlighted an unexpected, and steep, uptick in royalty levels in the Tupper Montney play in Canada.

Though the revised outlook is disappointing, performance in the third quarter specifically was generally higher than expected. Production was above the high end of guidance, and the firm's financial results were ahead of consensus estimates. The upside was partially driven by a mild Atlantic hurricane season, which led to lower downtime in the Gulf of Mexico than what management baked into its estimates. In addition, management highlighted that its newest Gulf of Mexico wells, in the Khaleesi, Mormont, and Samurai fields, are generally exceeding modeled projections by about 20%.

Murphy Oil repositioned itself as a pure-play exploration and production company in 2013, spinning off its retail gas and refinery businesses. Historically, the company’s capital efficiency was skewed to the weaker end of the peer group range, even after this transformation, but management has since narrowed the gap by downsizing the portfolio and shifting capital toward higher-margin projects.

The firm is a top-five producer in the Gulf of Mexico, which accounts for almost half of its production. It signed a joint venture agreement with Petrobras in late 2018, giving it an 80% stake in the combined assets of the two companies. Murphy has a number of expansion projects lined up there that should offset legacy declines and enable it to hold production flat in the next few years. These include Samurai, Khaleesi, and Mormont, which started contributing this year and are expected to collectively add about 30 thousand barrels of oil equivalent by 2025. There is regulatory risk: After entering office, U.S. President Joe Biden pledged to halt offshore oil and gas permitting activity to demonstrate his climate credentials. But high crude prices have made it politically unpalatable to follow through, and so far the only action taken was a temporary suspension that came into effect in early 2021 and was long since rescinded. We would not rule out a more comprehensive ban eventually, but for now it remains business as usual for Murphy.

Murphy also has onshore assets in several parts of North America. This includes 120,000 acres in the South Texas Eagle Ford play. Like other shale producers, the firm has made considerable progress cutting costs and boosting productivity since the post-2014 downturn. However, while the firm still has over 1,000 drillable locations in inventory, only around 350 of them are in the prolific Karnes County area. When this portion is exhausted, well performance, and thus returns, could deteriorate. In Canada, the firm is currently prioritizing the Tupper Montney gas play while natural gas prices in the region are more stable after a period of steep discounts caused by takeaway constraints that have now cleared.

The ability to generate durable excess returns on invested capital is a hallmark of companies with economic moats. Before 2022, Murphy had not earned its cost of capital since 2013, when Brent crude averaged $108 per barrel. The near-term outlook for crude is exceptionally strong once again and could commensurately drive up corporate returns, but we see this as a cyclical upswing and not a secular shift. Murphy is now investing in projects that offer decent returns at midcycle prices, but its capital base is still inflated by less attractive investments during previous cycles. As such, we see little chance that Murphy can maintain corporate returns in excess of the weighted average cost of capital, and accordingly we assign a no-moat rating.

Today, the firm is focusing on offshore exploration and development. This is probably the right move, since the company has a relatively short runway of top-tier drilling opportunities in the shale portion of its portfolio. We'd rather see it cherry-pick low-cost projects offshore than pour capital into lower-productivity shale acreage. Nevertheless, we doubt that Murphy's offshore portfolio can consistently compete on costs with the best shale opportunities, leaving the company with a higher average cost of production than the best of its shale-focused peers. In addition, like all E&P firms, the firm is exposed to a range of potential environmental, social, and governance issues that could hurt its ability to generate strong returns.

The most significant ESG exposures are greenhouse gas emissions (both from extraction operations and downstream consumption) and other emissions, effluents, and waste (primarily oil spills). Greenhouse gas emissions are the biggest threat and are unavoidable for oil producers. Firms can clean up their operations in the field as much as possible by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to reduce CO2 volumes being released into the atmosphere during the extraction process. Downstream emissions—at the refinery and beyond—are beyond producers' control, yet these account for the vast majority of total emissions. So, there's no such thing as a "green" oil producer. As consumers grow more averse to fossil fuels, the reputational risk increases for producers and the probability of widespread substitution away from fossil fuels rises. This also makes value-destructive regulatory intervention more likely (think fracking restrictions or carbon taxes). These threats are not likely enough to be included in our base-case forecasts, but because the impact would be material, it does further erode the firm’s moat potential.

Spills are mainly a concern for firms operating offshore, as Murphy does. Though the probability is very remote, a devastating accident like the BP Macondo disaster in 2010 could have a material adverse impact on Murphy, which could be forced to cover cleanup costs and perhaps face other legal repercussions. Spills also occur from time to time during long-haul transit over land, but Murphy has limited exposure, as this activity is typically outsourced to midstream firms. So there is no chance that the firm would be on the hook for an event like the Kalamazoo River (Michigan) spill, which also occurred in 2010.

Our primary valuation tool is our net asset value forecast. This bottom-up model projects cash flows from future drilling on a single-well basis and aggregates across the company's inventory, discounting at the corporate weighted average cost of capital. Cash flows from current (base) production are included with a hyperbolic decline rate assumption. Our valuation also includes the mark-to-market present value of the company’s hedging program. We assume oil (West Texas Intermediate) prices in 2022 and 2023 will average $94 and $77 a barrel, respectively. In the same periods, natural gas (Henry Hub) prices are expected to average $7.00 and $5.20 per thousand cubic feet. Terminal prices are defined by our long-term midcycle price estimates (currently $60/bbl Brent, $55/bbl WTI, and $3.30/mcf natural gas).

Based on this methodology, our fair value estimate is $34 per share. This corresponds to enterprise value/EBITDA multiples of 2.9 times and 2.9 times for 2022 and 2023, respectively. Our consolidated production forecast for 2022 is 177 mboe/d. That drives 2022 consolidated adjusted EBITDA to $2.7 billion, and we expect cash flow per share to reach $14.99 in the same period. Our 2023 estimates for production, EBITDA, and cash flow per share are 208 mboe/d, $2.7 billion, and $14.21, respectively.

As with most E&P firms, a deteriorating outlook for oil and natural gas prices would pressure Murphy's profitability, reduce cash flows, and drive up financial leverage. An increase in federal taxes or a revocation of the intangible drilling deduction that U.S. firms enjoy could also affect profitability and reduce our fair value estimate.

Material ESG exposures create additional risk for E&P investors. In this industry, the most significant exposures are greenhouse gas emissions (both from extraction operations and downstream consumption) and other emissions, effluents, and waste (primarily oil spills). In addition to the reputational threat, these issues could force climate-conscious consumers away from fossil fuels in greater numbers, resulting in long-term demand erosion. Climate concerns could also trigger regulatory interventions, such as fracking bans, drilling permit suspensions, and perhaps even direct taxes on carbon emissions.

As an offshore producer in the U.S., Murphy is particularly vulnerable. Its drilling campaign in the Gulf of Mexico requires ongoing approvals from the Department of the Interior. As this entity is controlled by the executive branch of the U.S. government, it can suspend permitting activity without congressional approval. Biden has pledged to withhold future oil and gas permits, although so far he has only enacted a temporary moratorium, which has already ended and only targeted new leasing (which means permits would continue to be issued for valid leases, like Murphy's, regardless). However, there is no guarantee that more restrictions will not come into force later.

Our Standard capital allocation rating reflects Murphy's average balance sheet, fair investment strategy, and appropriate distributions.

Roger W. Jenkins has been president and CEO since 2013, when Murphy became a stand-alone E&P company after spinning off its retail gas business and selling its U.K. refinery. The capital efficiency of the company that Jenkins took over was relatively poor. However, though his tenure included one of the deepest and most painful downturns the industry has experienced, Murphy has transitioned into a stronger and more competitive business by shedding weaker assets and pivoting to higher-margin resources, including those in the Eagle Ford Shale and Gulf of Mexico.

The firm has historically maintained a clean balance sheet, even before 2015, when many upstream firms were throwing caution to the wind and spending heavily to expand production. The aftermath of the COVID-19-related downturn in 2020, which came on the heels of a hefty acquisition for Murphy in the Gulf of Mexico, was the only period where the company had to cope with elevated leverage, and to management's credit, the ship was righted quickly.