Material Matters: Oil Market Tightening, LNG Risks, Mining Contractors Reviewed

This story features ORIGIN ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: ORG

 – Global oil demand tightening product stocks
 – JP Morgan lifts oil price forecasts
 – Barclays Capital expects oil to remain in range of past seven quarters
 – Australian LNG projects at risk of missing market window
 – Macquarie revises expectations for the sector
 – Broker also reviews outlook for contractors 

By Chris Shaw

Oil prices have recovered since late June, largely due to stronger demand from Japan, Germany and the US and downward revisions to non-OPEC supply. The strength of this demand has meant a continued tightening in product stocks.

To reflect the stronger than expected demand of recent months, JP Morgan has lifted its global oil demand growth forecast for 2012 by 180,000 barrels per day to 750,000 barrels per day. The forecast for 2013 has been lowered slightly to 1.14 million barrels per day.

JP Morgan suggests while many factors have likely contributed to the pick up in demand evident in the June quarter, a major contributor was an oil price fall of around US$35 per barrel during the period. This offered an opportunity to boost inventories, as well as to rekindle deferred demand.

For JP Morgan this demand pick-up has been enough to generate increases to Brent crude price forecasts through the balance of this year and into 2013. Brent is now expected to average US$105 per barrel over the course of the final quarter this year, up from US$100 per barrel previously. West Texas Intermediate (WTI) is expected to average US$87 per barrel over the same period, down slightly from a previous forecast of US$90 per barrel.

That JP Morgan's revisions to price forecasts for the final quarter of 2012 have been relatively modest is not a great surprise, as Barclays Capital noted for the past seven quarter Bent crude quarterly average prices have been in the range of US$105-$120 per barrel. This is despite intra-day prices over 2011 and 2012 showing a range of more than US$35 per barrel.

Barclays doesn't see prices moving out of this range in the final quarter of 2012, forecasting an average price for the period for Brent crude of US$117 per barrel. One potential variable that could shift prices outside the range of the past two years is the US presidential election, as Barclays suggests once this is behind the market, changes to the geopolitical landscape and the political sensitivity of oil prices are likely to become the key theme.

In the view of JP Morgan, the lower baseline for inventories evidenced over the past couple of months and reduced downside economic risk supports an improved oil price outlook. The rebound in crude also implies the global economy has been stronger than data indicate, with lagging economic indicators such as PMIs potentially not describing current market conditions. 

This should become evident in 2013 oil prices, as JP Morgan is now forecasting an average for next year for Brent crude of US$113 per barrel, up from US$104 per barrel previously. WTI forecasts have also increased to US$100.50 per barrel next year from US$99 per barrel previously.

While forecasts have been increased, JP Morgan notes its new estimates remain below the forward curve for much of the first half of 2013. An expected scenario of easing demand prompting OPEC members to lower output is anticipated by the middle of next year. When combined with an expected pick-up in economic momentum around the same time is seen as supportive of higher prices in the second half of next year.

In the LNG market, Macquarie suggests the combination of strong demand growth and a slowdown in the pace of capacity additions suggests a tighter medium-term market. Longer-term, which in this case means beyond 2017, the outlook is different as there are a growing number of proposed projects expected to compete for what appears to Macquarie to be finite longer-term demand.

As Macquarie notes, over the past 18 months around 150 million tonnes per annum of new capacity has been announced. This amount equals more than 50% of current global demand and in the longer-term suggests upward pressure on development costs and downward pressure on prices.

In Macquarie's view the market window for Australian LNG projects is closing quickly, as the supply story moves to North America and East Africa given the potential for cheaper supply and the fact Australia has reached what may be viewed as acceptable market share limits.

As the outlook for new project sanctions becomes tougher, the Australian LNG sector is becoming more of a development story, something Macquarie suggests is likely to make investors more nervous given the associated risks.

With a stronger supply outlook longer-term, buyers are pressuring to shift the market spot or hub-based pricing, while sellers appear happy to stick with the current oil-indexation system. The expectation of a move towards spot-based pricing for LNG will shift additional pressure onto sellers, Macquarie noting this will add to the existing funding and development challenges being faced.

The result is Macquarie has trimmed pricing slopes for uncontracted LNG volumes, which when added to some increases to project risk weightings causes the broker to lower price targets across the sector. Santos' ((STO)) price target has been cut by 6% to $16.00, while for Origin Energy ((ORG)) the target falls by 10% to $15.50. 

Macquarie has cut its price target for Woodside ((WPL)) by 4% to $37.50, at the same time downgrading its rating on the stock to Neutral from Outperform. The downgrade reflects the fact while more than 60 million tonnes per annum of Australian LNG capacity has been sanctioned since Woodside began the Pluto project, none of it has been Woodside's capacity. 

This means the Browse and Sunrise projects and the Pluto expansion are running close to missing the market window. This creates an issue for Woodside as if issues at the likes of Browse and Sunrise cause timelines to slip further, there will be little in terms of projects under development as the company hits peak production next year. 

This potentially leaves management with a need to consider M&A options, which Macquarie suggests creates an additional problem given buying resources is too expensive and buying exploration is too long-dated.

This M&A risk, along with the unresolved Shell overhang and a fuller relative valuation are enough for Macquarie to justify the downgrade in rating. Macquarie retains Outperform ratings on Oil Search ((OSH)), Santos, BHP Billiton ((BHP)) and Origin Energy.

As a basis for comparison, Sentiment Indicator readings for the stocks according to the FNArena database stand at 0.9 for Oil Search, Origin Energy and Santos, 0.6 for BHP and 0.4 for Woodside.

Any impact on the outlook for major Australian oil and gas plays is likely to have some flow through impact on contractors servicing those companies, so Macquarie has also run the ruler over the listed contractors in Australia post recent profit results.

In general, Macquarie notes revenues were better than expected but margins were weaker than forecast, though up on FY11 levels. While growth expectations for FY13 have been moderated in some cases, the most important factor in terms of any changes to expectations has been end market exposures.

Overall, Macquarie is forecasting a 12% increase in sector earnings per share (EPS) in FY13, with a preference for those stocks with exposure to oil and gas the most preferred. This is followed by exposure to iron ore.

Among stocks under coverage, those most exposed to the oil and gas sector in terms of overall revenues are WorleyParsons ((WOR)) at 68%, Transfield ((TSE)) at 30% Monadelphous ((MND)) at 10-15% (but expected to increase towards 30% from FY14) and Leighton Holdings ((LEI)) at 10% of group revenues.

Key stock picks for Macquarie account for factors such as relative earnings certainty, strong balance sheets and solid yields on offer. Among stocks covered Macquarie rates WorleyParsons, Monadelphous and Downer EDI ((DOW)) as Outperform, the latter given an attractive valuation relative to the sector in general.

Both Boart Longyear ((BLY)) and Transfield are rated as Neutral, while UGL ((UGL)) and Leighton both score Underperform ratings, as does ALS Limited (ALQ)), the former Campbell Brothers. 

Regarding Boart Longyear and ALS, Macquarie believes a more cautious approach to stocks exposed to the outlook for exploration is but appropriate at present, while Leighton is dealing with some balance sheet pressures and UGL faces some power project problems and is dealing with lower revenues.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms