The Inconvenient Truth About Energy Stocks

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

By Rudi Filapek-Vandyck, Editor FNArena

Ever since I warned investors in 2008 the temporarily loss of sanity and good judgment by the world's investment community on global oil prices would lead to many losing their shirt from owning shares in energy stocks, the sector has continuously featured in my live presentations to investors around the country.

Not because oil and gas stocks have proved such a wonderful investment since the bursting of the Bubble in 2008. My favourite observation prior to the current calendar year was always that long term, Buy-and-Hold investors have seen little benefit from owning equity in oil and gas producers since the beginning of 2006. Since none of the players in Australia pays a decent dividend, it hasn't exactly been worth the waiting, unless shares had been bought during the troughs that occurred during those seven long (and volatile) years.

Mind you, there have been two rallies of 50% and more throughout the period and for stocks like Santos ((STO)) this year has delivered yet another 50%-plus experience (if we start from the trough in June this year), but the inconvenient truth remains that Santos' share price has barely budged from the $13 price level at which the stock was priced in early January of 2006.

At the start of calendar 2013, Santos shares were trading above $11, which implicitly implies a negative real return over seven years. The shares are currently trading below $15 which is still a long way off the all-time high reached in June 2008 when the shares briefly touched $21.50.

Don't get me started on Woodside Petroleum ((WPL)). This may have escaped most investors and commentators, but despite all the hullabaloo about the energy sector being one of the strong performers this year, as investors sought refuge in energy while miners were mostly seen struggling, Woodside shares are only up by the smallest of margins since January.

Woodside shares peaked at $70 in June 2008. Don't look what the shares are priced at today, it'll only hurt your eyes, unless you have enough spirit to respond with a big smile. (Might be easier too if you are not among the many shareholders who felt the stock had to be in their portfolio for reasons of diversification).

The story has not been different for the smaller players in the industry: unless investors managed to time their entry near bottoms and troughs, there has been a lot of volatility, but little in terms of sustainable investment returns.

Good for trading. Not so good as an investment. That's how I described the sector in years past and the statement still stands, despite the sector experiencing a re-rating thus far this year. That re-rating, it has to be pointed out, has largely closed the gap from the post-2008 bear market for Australian equities, so now the obvious question becomes: what's next?

It has been my view that those operators with large LNG projects on the horizon will gradually turn into a cash flow annex dividend play. I believe this has already become a fait accompli for Woodside whose shares are currently trading on an implied FX-adjusted, forward looking yield of circa 6%, both for this year (year to December 2013) as well as for next.

Woodside's peers Santos, Oil Search ((OSH)) and Origin Energy ((ORG)) will move through a similar transformation in the 2-3 years ahead. All else being equal, this should ensure that shareholders will reap more benefits from owning the shares in the seven years ahead in comparison with the rather subdued investment returns from the past seven years.

At least dividends, while instantly taxable, don't disappear in the next wave of sector selling.

However, a recent study by analysts at Credit Suisse has made me realise that even this dividend transformation story remains painfully incomplete. As I tend to emphasise time and time again, when a company such as Woolworths builds a national network of retail outlets, it owns a durable asset that only requires maintenance and, maybe, refurbishment.

That's a much easier and more sustainable proposition than finding an oil well that proves economically viable. Once it is up and running, everybody knows the fluids are going to stop flowing at some point, so management is essentially fighting a battle against future erosion. At some point the decline in production and revenues will manifest itself and become visible to everyone.

It is Credit Suisse's view that all major players in the oil and gas industry in Australia will be facing exactly this battle in the years ahead, and it remains inconclusive whether they all can and will turn this fight into their favour (and to shareholders' benefit).

First up, and as things stand right now, 2014 is likely to mark the year of peak-production for Woodside Petroleum (at 93MMBOE according to CS' estimates). By 2020, and all else remaining equal, Woodside's annual production will have declined by some 25%, projects the CS study.

It goes without saying that management and the board at Woodside are not going to take this erosion as a given and they will seek, and find, ways to at least maintain the perception of Woodside still being a growth company. This is where things get "interesting". Finding new projects has become a difficult and expensive undertaking, across the sector and across the world.

Apart from this, Woodside will find itself increasingly at loggerheads with its long-suffering shareholders who want dividends in the absence of sustainable share price gains (they know from direct experience what I have been telling investors in years past). But, as also pointed out in the CS study, one cannot possibly have both.

Either Woodside accepts the gradual erosion in its production levels and keeps the shareholders happy with high dividend payouts, or it will use some of its cash flows to reinvest in new projects, which may prove disappointing, expensive and not adding much value after all, but -and this is one of the key conclusions drawn in the CS study- this will automatically lead to reduced dividends.

Investors should also note large oil and gas producers have a mandatory capex burden to maintain their projects and keep production flowing. CS analysts estimate Woodside will have to spend $2.47bn annually, through-the-cycle, to do just that.

Bottom line: don't assume the current yield on Woodside shares is sustainable, it more than likely won't last past next year. Also don't assume Woodside's share price will only appreciate further between now and 2020. If the upcoming decline in annual production cannot be addressed successfully and rapidly enough, the share price will have to re-set at a lower price level, assuming investors still want 6% in annual yield?

It'll take a little longer before Santos and Oil Search arrive at the same crossroads as Woodside, but both are inevitably en route to that same inflection point. CS estimates Santos' production will peak in 2018, while Oil Search might have the luxury to add a third train to its PNG LNG project which means production is likely to peak in 2020 instead of in 2015 if train three does not materialise.

Oil Search, by the way, has been the stand-out exception in the local oil and gas sector since 2006 and it has consistently featured as such in my presentations and writings. CS analysis suggests the relative outperformance of Oil Search shares is going to last a while longer. Assuming T3 will occur, the analysts estimate the shares today are on a real and sustainable dividend yield of no less than 9.8% and even without T3 the sustainable yield should still read 6.8%.

For Woodside and for Santos, the CS study is essentially suggesting investors should prepare for disappointment and for lower annual dividends than they are inclined to expect. CS believes the real and sustainable yield for Woodside is around 4.8% and for Santos it currently sits at 5.2%.

That's in both cases significantly above what shareholders have enjoyed since 2006.

It goes without saying that part of the problem for energy producers is that crude oil prices essentially have stopped climbing. If we concentrate on Brent, which has become the world's de facto oil price benchmark, then the price of oil has now been range-trading since the recovery from the post 2008 Bubble sell-off.

I happen to believe this is not going to change in a hurry.

Analysts at Citi recently published a series of in-depth reports on the world's energy markets and their conclusion is that energy markets are going through intense transformation right now and the idea that the world will always buy oil and gas at virtually every price will increasingly be challenged in years to come. Right now, natural gas, in all its forms and origins, is developing into the next big thing, but behind the curtains solar and wind power are making significant inroads too.

Citi's studies are also suggesting that investors can only be certain that cheap gas projects will be a guaranteed winner, with the emphasis on "cheap" not on "gas". Various future options in the Woodside petroleum portfolio of assets are in essence sitting high on the global cost curve, highlight analysts at Citi. This not only means above average risks (and the share market should price this as such) but increasingly also the possibility that those projects will actually never make it to the final stage.

Another consideration to take on board is that the many changes that are occurring inside the energy space (with coal becoming a major loser) are going to impact on energy retailers just as peers in the US and in Europe are currently being challenged by non-traditional sources, new technologies and new market entrants, and forced into adopting new business models.

You can bet your bottom dollar that it will take a few years still, but eventually Origin Energy and AGL ((AGK)) will be facing the same battles.

Never a dull moment at the office? Not when you're embedded inside the dynamic energy sector, so much seems certain. For investors, the challenge will be to separate the temporary rallies (and accompanying market excitement) from sustainable value creation. Probably best to try to join at a price that is as cheaply as possible.

Right now, most energy stocks in Australia are not particularly cheap. Investors can take guidance from the relatively small gaps that remain between share prices and consensus targets. Among the larger producers there seems to be a hierarchy in terms of operational challenges: Woodside is facing serious tests first, then comes Santos and (much) further out is Oil Search.

Smaller players like Beach Energy ((BPT)), Senex Energy ((SXY)) and Drillsearch ((DLS)) may represent more potential, but they also carry a lot more risk and come with a lot more volatility.

Ultimately, it may well turn out that, longer term, the best investments in oil and gas in the Australian share market are achieved via BHP Billiton ((BHP)) -though only as an add-on to the vast interest in iron ore- and via WorleyParsons ((WOR)), though the latter now comes with more risk than usual in the short term.

(This story was written on Monday, 14 October 2013. It was published on that day in the form of an email to paying subscribers).

(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)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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Rudi On Tour

– I have accepted an invitation to present to ATAA members in Canberra in late November

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