Which Energy Stocks Are In Play In 2014?

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-Step change coming from PNG LNG and GLNG
-Transforming stocks are favoured
-Upside to energy prices seen limited
-Profitability matters globally
 

By Eva Brocklehurst

Energy stocks should keep the bears at bay this year. That's what most brokers expect, although the extent of the optimism varies. What is generally agreed is the fact that two big Australian projects will be very important to the sector's health in 2014. PNG LNG is entering production this year and GLNG is set to deliver on long-held promises as it heads for start-up next year.

BA-Merrill Lynch expects a step change in returns and cash flow as a result of these two projects. The broker does suspect that the market is waiting for the ultimate execution of these projects before committing fully. Merrills suspects this cautious attitude leaves the cash flow potential of the likes of those involved, such as Oil Search ((OSH)) and Santos ((STO)),  undervalued. Deutsche Bank's view is somewhat different. The broker notes 2013 was a year when large cap energy stocks under coverage outperformed and the market demonstrated an increased willingness to de-risk LNG projects under construction. Acknowledging that this de-risking needs to play out further, the broker thinks the outlook is strong for both Oil Search and Santos.

The spot market for LNG is expected to stay tight to 2015, according to Merrills, even as the Australian projects ramp up. The price may be dampened by the fact that Japan is looking at a record trade deficit for 2013 and the country's utilities are not alone in feeling the stress from energy prices so there's a concerted effort to keep a lid on prices. Merrills suspects the re-negotiation of Pluto LNG pricing by Woodside Petroleum ((WPL)) will be the acid test for LNG prices.

Morgan Stanley also believes the fact that Japan is the largest importer of LNG globally should provoke some concerns about pricing this year. The price Japan pays for LNG on a monthly basis is the benchmark for long-term supply. Prices are set by contracts between producers of LNG around the world and buyers in Japan. Morgan Stanley observes the majority of Australia's existing, as well as future, LNG production is already contracted at oil-linked prices. Woodside is an exception, the broker acknowledges, with Pluto LNG prices subject to upward revision from April 2014.

In terms of the oil price, Merrills is cautious and expects Brent crude to trade down from an average of US$109/bbl in 2013 to US$105/bbl this year, dipping to US$90/bbl at some point. Demand from emerging markets is expected to moderate and there is potential for increased supply from Iran as well as US production growth. There is limited upside for the price because energy, as a percentage of US GDP, is just 150 basis points below the 9% threshold, a level which the broker cites has historically led to a destruction of demand.

UBS expects Brent to average US$105/bbl in 2014 as US demand picks up and supply growth outside of North America fails to meet expectations. The broker thinks the magnitude of non-OPEC supply growth means that markets are not dependent on any OPEC recovery. Furthermore, support for prices could come from persistent strength in OECD demand. If OPEC suppliers such as Libya recover more quickly then the broker suspects there would downward pressure on prices and Brent could slip to US$90/bbl in such an event.

How do the local equities look? Oil Search is the preferred pick among Australian majors for Morgan Stanley while the broker applies an Equal Weight rating to Origin Energy ((ORG)), Santos, Beach Energy (((BPT)) and Woodside. Morgan Stanley prefers Aurora Oil & Gas ((AUT)), Roc Oil ((ROC)), Horizon Oil ((HZN)) and Karoon Gas ((KAR)) among the small cap Australian energy stocks. In this segment, the broker is Equal Weight on Senex Energy ((SXY)) while Underweight on AWE ((AWE)) and Drillsearch ((DLS)).

Deutsche Bank expects crude prices will decline this year and expects Brent to average a decline of around 11% on 2013 levels in US dollar terms. A weaker Australian dollar offers some protection for those reporting in that currency. Accepting the difficulty posed for equities to outperform if the related commodity price falls, the broker does point to the fact that, in 2013, all larger cap energy stocks outperformed both Brent and the broader market. Still, Deutsche Bank expects company-specific catalysts to prevail this year and this means PNG LNG, GLNG and APLNG are at the forefront of a de-risking of those equities involved.

The bias is towards those that are transforming their businesses, such as Oil Search, where a long period of intensive investment should bear fruit, in Merrills' opinion. This broker also prefers Sundance Energy ((SEA)) in the small-medium cap segment because of its substantial production growth and large position in the Mississippi/Woodford acreage as well as Roc Oil for its cash flow and higher production expectations this year. Merrills avoids stocks with long-dated gas assets where the route to commercialisation is still unclear, such as Horizon Oil. Interestingly, Woodside is the broker's least favoured large cap energy stock. Merrills wants to see improving returns on exploration and a decision on Leviathan before becoming more positive but is more bullish about the second half, as prices are negotiated for Pluto and the Browse project matures.

Deutsche Bank prefers Oil Search and Santos. Drillsearch is the broker's preferred emerging exposure as it provides the strongest production momentum in the near term and Deutsche Bank likes Senex for the new discoveries that are being brought into production. Buru Energy ((BRU)) is also cited as one to watch, as production will come from the Ungani oil field by the end of the year.

UBS has upgraded Roc Oil recently to a Buy recommendation after a fall in  the share price fall. The broker also makes Aurora a key choice, despite the fact the company's exposure to US gas has reduced valuation. Expectations for oil prices and lower AUD assumptions means the broker expects Woodside's yield to improve to around 6.7%, fully franked.

On the global stage, Citi is still circumspect regarding big European energy stocks as these endured a tough December quarter. The broker finds it hard to see areas where these stocks can excel and believes profitability has been challenged by an environment of flat nominal oil prices and deteriorating returns on incremental upstream investment. The broker wants oil majors to acknowledge the fact that profitability matters and therefore believes they must be more disciplined with capital and financing.
 

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