Lower Oil Price, But Value Remains In Oil Equities

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            [1] => ((TAP))
            [2] => ((AWE))
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This story features ROCKETBOOTS LIMITED.
For more info SHARE ANALYSIS: ROC

 – BA-ML and JP Morgan adjust energy sector models
 – Earnings forecasts and valuations adjusted
 – Value still on offer in the sector 
 – Both brokers update on preferred exposures

By Chris Shaw

Earlier this week FNArena noted market expectations are for oil prices to strengthen in the second half of this year even though they are now anticipated to reach lower price levels than previously projected (See: Oil Prices Expected To Bounce, 6/6/12). In line with this assessment, BA Merrill Lynch has now joined the queue of market experts to also lower its oil price forecasts through 2013.

The cuts reflect a number of factors, including the ongoing eurozone issues, softer than expected growth in emerging markets and the US and some recent upside surprises to supply. Accounting for this, BA-ML has cut its forecasts for the second half of this year to US$106 per barrel for Brent crude and to US$97 per barrel for West Texas Intermediate, down from US$116 and US$107 per barrel respectively.

The cuts in 2013 are similar, as BA-ML now expects an average Brent crude price next year of US$110 per barrel and a WTI price of US$100 per barrel. These have been lowered from previous forecasts of US$120 and US$111 per barrel respectively.

The changes impact on earnings expectations and valuations for Australian energy stocks under BA-ML's coverage, though the broker notes the impact of the fall is cushioned somewhat by expectations of further weakness in the Australian dollar.

The earnings impact is greater, as forecasts for the next two years for the likes of Woodside ((WPL)) have been cut by 7-10% and for Oil Search ((OSH)) by around 13% in both years. The impact is greater for smaller cap plays, as forecasts for Horizon Oil ((HZN)) fall by 19% and 11% respectively in each of the next two years and for Roc Oil ((ROC)) by 25% and 23%. 

BA-ML has also run some more bearish scenarios, where oil prices fall to US$80 per barrel and the Australian dollar accordingly weakens further against the US currency. This analysis suggests to BA-ML stocks rated as Buy remain well valued under the US$80 per barrel scenario.

BA-ML's Buy rated stocks among the Australian energy plays are Santos ((STO)), Oil Search, Karoon Gas ((KAR)), Horizon and Roc, while the broker has a Hold rating on Tap Oil ((TAP)). Underweight ratings are ascribed to Woodside, Aurora Oil and Gas ((AUT)), Beach Energy ((BPT)), AWE Ltd ((AWE)) and Nexus ((NXS)).

JP Morgan agrees there is value in the sector, even as short-term oil price forecasts have been revised slightly. JP Morgan has cut its WTI estimate for this year by US$2 per barrel while leaving its forecast for Brent crude unchanged, while the broker's long-term oil price forecast of US$90 per barrel is unchanged.

As most of the stocks under the broker's coverage are trading below base case risked valuations based on these forecasts, upside is material. On forecasts of a long-term oil price of US$90 per barrel and an AUD/USD exchange rate of $0.80, average upside across the sector stands at a little more than 40%.

This upside potential has seen the broker review its coverage on a relative basis, which has resulted in some changes to ratings. Woodside has been upgraded to Overweight from Neutral, reflecting improved valuation following recent share price movements.

While Shell's stake and reinvestment risk remain potential issues, positives such as the ramp up of the Pluto LNG project and updates on Browse FEED tenders and expansion options for Pluto are offsetting positives. 

To offset this upgrade among the large caps, JP Morgan has downgraded Oil Search to Neutral from Overweight, as while the PNG LNG project is high quality the broker sees less valuation upside at current levels than is on offer in either Woodside or Santos. The latter continues to be rated Overweight.

At the smaller end of the market JP Morgan has downgraded both Aurora and Beach to Underweight from Neutral previously, reflecting the fact while both have attractive core assets there is better valuation upside on offer elsewhere in the sector.

Preferred smaller cap plays for JP Morgan are AWE and Roc Oil, both of which continue to be rated as Overweight.

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