Crude Oil, The New Fool’s Gold?

This story features SANTOS LIMITED, and other companies. For more info SHARE ANALYSIS: STO

 In this week's Weekly Insights:

– Cautious Seems Best
– Crude Oil, The New Fool's Gold?
– Rudi On Tour
– Nothing Ever Changes, Or Does It?
– Rudi On TV

By Rudi Filapek-Vandyck, Editor FNArena

Prologue: Cautious Seems Best

There are times when index movements in Australia don't provide investors with a full and accurate reflection of what exactly is going on in the share market. This is one of such times.

At face value, it appears the broader index is slowly shedding some of the gains achieved since mid-September, still largely standing firm despite many suggesting a "correction" surely must now be on the cards.

This picture is heavily distorted by frantic portfolio swapping into banks and resources stocks, which are holding up major indices despite money flowing out of the market elsewhere.

With many a chartist calling for short to medium term weakness, it's probably best investors adopt a more cautious approach, if they haven't already.

Crude Oil, The New Fool's Gold?

"The race ain't always to the swiftest nor the fight to the strongest, but that is the way to bet!"
[1920s American sports writer, Grantland Rice]

Even when crude oil prices sank below US$30/bbl earlier in 2016, and the likes of Goldman Sachs suggested it wouldn't require much more in terms of additional bad news to push the price of a barrel of liquid gold as low as US$20/bbl, the share market never really believed it would happen.

If it would, it'd be nothing more than a temporary blip, a flash crash if you like, but nothing that can possibly stay in place for more than a few hours, maybe a few days, max.

This seems like a strange conclusion to put forward in light of the at times extreme volatility that has characterised the oil & gas sector globally since June 2014, which is when oil prices abandoned the three year long pricing regime above US$100/bbl, and then rapidly descended to US$40/bbl.

At the time, by which I mean mid-2014, Woodside Petroleum ((WPL)) shares were seen comfortably trading above $40, Oil Search ((OSH)) shares topped out at $9.80, Santos ((STO)) was north of $13 and Origin Energy ((ORG)) was reaching for $14. Considering those share prices have since bottomed around $25, $6, $2.84 and $3.64 respectively, most investors in the sector would probably find it hard to fathom share prices should, all else being equal, have sunk much lower were they to reflect the deflation in oil prices.

After all, this is exactly what happened to mining companies, but not for oil.

Note the relative underperformance for Santos and Origin Energy in comparison with Woodside and Oil Search was due to the need for balance sheet repair which subsequently led to cheap and discounted equity placements by the first two.

Optimism Sticks With Energy Sector

In simple terms: share market valuations for large cap oil & gas producers never reflected the bottom of the cycle, beaten down price of oil, instead investors always assumed there would be a recovery, albeit with exact timing unknown. In 2016, for example, most share prices in Australia, both for producers large and small, have been implying crude oil will return to US$60/bbl and beyond in the future.

We know this because energy sector analysts at UBS and Credit Suisse kept publishing regular updates on this specific observation.

One might be inclined to think this is going to weigh upon the sector's performance at some stage, even with a higher oil price. This is probably correct, though not necessarily in the short term. In the short term rallies higher in oil prices are likely to also push up share prices for the relevant exposures, even if this implies share prices starting to reflect crude oil prices above US$70/bbl.

Which, if you take note of Credit Suisse's latest update on the sector, is about where we are… now.

This is starting to make a lot less sense, unless, of course, OPEC will get its way and crude oil prices beat current analysts' expectations which, on average, are for Brent to average mid-US$50/bbl next year and around US$60/bbl in 2018. Some analysts are still projecting a longer term price of US$70/bbl, but Credit Suisse, for example, last week reduced its long term price assumption to US$65/bbl.

Now everyone understands why energy analysts at Credit Suisse think Australian oil & gas companies are too richly priced, both in comparison with global peers and with the likely price of oil in the years ahead. It has triggered the extraordinary admission the energy team is close to the point whereby clientele shall receive the advice to fully abandon all exposure.

"Such is the overvaluation in the sector that we are almost at the stage where we can argue having no exposure to the sector."

The Forgotten FX-Translation

Of course, analysts expectations are just that, I hear you all think. The team at Credit Suisse might be forced to eat humble pie if not next year, then maybe the following year, or it could be next month.

But things are actually even worse, apart from the fact that Credit Suisse's estimates and observations are not that different from most fellow energy experts elsewhere.

It appears investors in Australian oil & gas stocks have forgotten all about the currency. When analysing what exactly is priced in at today's share prices, most analysts use AUD/USD conversion that is below today's 0.76 so in actual terms, taking into account the Australian dollar already is much stronger than projected by most, listed energy producers in Australia could already be reflecting a longer term oil price that is unlikely to materialise.

On Credit Suisse's most recent calculations, share prices for Woodside, Oil Search, Santos and Origin Energy are implying, at spot AUD/USD, crude oil priced at US$72bbl, US$70bbl, US$62bbl and US$64bbl respectively. Assuming a stronger oil price also coincides with a stronger Aussie, at US80c the implied numbers rise to US$77bbl, US$72bbl, US$63bbl and US$68bbl.

For good measure: globally (outside Australia) oil and gas producers' share prices are incorporating market expectations for a return to US$60/bbl, not to US$70/bbl which is what appears to be the case in Australia.

Note: Credit Suisse's numbers are not materially different from estimates published by others, like UBS, Citi and Macquarie.

It's About Gas Too

If you thought surely things cannot get even more complicated, with possibly even more negative implications for future share prices of oil and gas producers in Australia, well, you are about to be proven wrong.

Most oil and gas producers in Australia, at least among large caps, are more gas than crude oil. This may not matter much when prices for natural gas ("LNG") are moving in lock step with West Texas Intermediate (WTI) or Brent, but it matters when this is not the case.

The elephant in the energy market, one that is not receiving the equivalent coverage in Australia, is that Asian LNG markets will be oversupplied in years to come. Indeed, a recent sector update by energy analysts at Citi stated "We see a risk over the coming 12 months that the market becomes more positive on oil but more bearish on LNG".

It won't be a decisive factor in the short term. LNG producers in Australia (which are all of Woodside, Oil Search, Santos and Origin Energy) are protected through long term delivery contracts that are, at their core, oil price derivatives. In most cases, contract prices are based upon Japanese Custom Cleared (JCC) prices, with a three month lag. In other words, in the short term these producers should enjoy the catch up in LNG prices to the recent move higher in crude oil (in double digit percentage, mind you).

Longer term, a disconnect between crude oil and LNG raises the possibility of "price re-opener discussions", and if low prices are sustained, of contract renegotiation. The market firmly believes in contract sanctity as long as the price gap isn't too large, or short-term only, and for as long as customers are not making too many unhappy noises.

Citi analysts, for one, subjected the sector in Australia to additional scrutiny about leverage to/impact from lower-for-longer LNG prices (which is what we are staring at on current market projections). The analysts came to the conclusion that LNG exposure in itself should not be a prime motivation to not invest in the sector. Crude oil prices have a larger impact for all.

This may be so in theory, but it doesn't account for market sentiment were LNG prices to stay lower for longer or for the fact that share prices already are assuming higher crude oil prices than the world has seen since April 2015.

Fracking In The US Of A

Higher oil prices are what most stakeholders in the global economy are welcoming right now. Central bankers, desperate to see inflation perk up, are all for it. OPEC and major producers elsewhere are enjoying immediate benefits. And investors, given the close correlation in direction for crude oil futures and risk assets in 2016, are equally cheering from the sidelines.

In the US, the energy sector has been one of few consistent pillars supporting economic growth, until early this year when prices fell too low and investments stopped. Imagine what a resumption in sector capex can do to the USA's economic outlook.

But rising oil prices are not a one-way street. There is an automatic offset through higher costs for consumers and firmer expectations for additional tightening by the Federal Reserve. It is also likely a stronger for longer oil price can push AUD/USD towards, and possibly beyond, 80c. Above anything else, stronger oil creates the ability for dormant production to join in. Already, the number of operating rigs is rising again in the USA where the fracking industry has become the global swing producer du moment.

With oil futures in contango, meaning deliveries further out in time are higher priced than short term contracts, it doesn't take much more upside to allow US frackers to hedge their output at, say, US$55/bbl, and restart operations again. This is one key factor that has the potential to quell current market optimism, in particular were crude oil futures to rise further.

Thus far, many a sector analyst is assuming US fracking won't be able to return to prior output levels while growing demand, and OPEC discipline, should create a global deficit. The exact timing of this is dependent on a number of unknowns, like how much production is likely to restart in the USA?

Miners Versus Energy

The key difference between mining stocks, like BHP Billiton ((BHP)) and Rio Tinto ((RIO)), and large cap oil & gas producers in Australia is the first group is still catching up to higher commodity prices. Flat prices from here onwards will continue to feed into higher profit and cash flow estimates.

Whereas share prices in the energy sector already are assuming a higher price for oil in the future. This means short term rallies in line with oil market optimism can push implied valuations into never-never land. Credit Suisse analysts put it as follows: "at some stage the 'if oil goes to US$70/bbl the stocks will price in US$90/bbl' will not work".

It is anyone's guess as to how exactly this disconnect between share prices and crude oil prices will correct, or when, but it won't continue into eternity. In the short term, of course, none of such considerations need necessarily to apply. Longer term investors might want to take notice, however.

Despite market's renewed enthusiasm in recent weeks, on my observation most share prices are still below levels from 2015 and they have essentially moved sideways throughout 2016, albeit through plenty of troughs and peaks. I think premature optimism is one key factor in this development. In contrast, Whitehaven Coal ((WHC)) is up 169.5% from twelve months ago, while South32 ((S32) has gained 68%. Can anyone spot the difference?

Those investors who bought in after sector pull backs have fared much better, which might be a more rewarding strategy to play the energy sector.

Another more suitable strategy might be to seek out companies that have the ability to surprise to the upside, irrespective of oil price movement or investor exuberance. A well-timed, attractive acquisition from Woodside Petroleum could be just one such catalyst, but investors have been speculating on exactly such an announcement for at least two years now.

Outside the top echelon, Karoon Gas ((KAR)) surprised friend and foe recently by negotiating a potentially company transformative deal with Petrobas to buy into the Bauna and Tartaruga Verde fields offshore Brazil. Any deal might require more equity than Karoon is able to raise and thus far financial details are not available.

Above anything else, investors are probably doing themselves one big favour by not getting blinded by supposed potential upside. Watch out for the downside, in particular after the recent rally, and even more so were oil prices to rally further and longer.

Higher prices too soon will eat away upside potential next year. That's pretty much a given.

(P.S. I know BHP Billiton is now a major oil producer too, but its downside from too frothy oil enthusiasm should be insulated, to a certain extent, by double-digit upside to cash flows and profits from better prices in bulk commodities).

Rudi On Tour

I will be presenting:

– Christmas Special for Chatswood members of Australian Investors' Association (AIA), December 14, 7pm

– To Sydney chapter of Australian Shareholders' Association (ASA), December 15, noon-1pm, Sydney Mechanics School of Arts, 280 Pitt Street

– To Perth chapters of Australian Investors' Association (AIA) and Australian Shareholders' Association (ASA) on 7 February 2017

Nothing Ever Changes, Or Does It?

Yes, of course, investing in the share market is never really different and best working strategies today are the same that worked pre-GFC. Seriously. I tell you, seriously.

Now that we had a good laugh about it, let's get straight to business. This is a low growth environment. Has been since 2010 (it was masked at the time because of the V-shaped recovery from the global recession) and it is not likely to change fundamentally in the near term. I wrote a book about this (see below). This means investment strategies must adapt. You'll be turning your portfolio into a wish list for dinosaurs otherwise (and your returns will be a reflection of it).

Those not afraid to contemplate "this time is different" can subscribe to FNArena and read all about it in our bonus eBooklets 'Make Risk Your Friend' (free with a paid 6 or 12 months subscription) plus the freshly published eBook 'Change. Investing in a low growth world' (equally free with subscription, or available through Amazon and other online distributors).

Here's the link to Amazon: https://goo.gl/XVMzmP

See also further below.

Rudi On TV

– On Thursday, I will appear as guest on Sky Business, 12.30-2.30pm
– On Friday, around 11.05am, on Sky Business, I shall make a brief appearance through Skype-link to discuss broker ratings for less than ten minutes

(This story was written on Monday 17th October 2016. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via Editor Direct on the website).

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– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
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– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
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