Is It Time To Reconsider Australian Energy Stocks?

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– Price stability seen approaching
– Geopolitics remains an unknown
– Cautious investment recommended
– Preferences vary

By Greg Peel

It is fair to say no one saw the spectacular collapse in global oil prices coming – a price pullback yes, from geopolitically influenced levels above the US$100 per barrel mark, but a plunge into the forties was not something one read about in any analyst outlooks.

Two factors have caught the world by surprise. Firstly, everyone knew the US shale revolution would have a meaningful impact on global supply, but no one was quite prepared for the scale and speed of that impact. Secondly, it was assumed OPEC would respond to lower oil prices with production cuts as it had always done in the past, so oil markets went into shock when OPEC this time stood its ground.

With US benchmark West Texas Intermediate crude most recently seeing some consolidation in the US$42-48/bbl range, the great debate is on as to whether such consolidation represents a bottom forming. Some say yes, while others still believe we must see prices in the thirties before we’ll again see fifties. Most analysts expecting prices to rise from here do not expect any rapid rebound, but do see prices ultimately settling back towards the seventies, albeit probably over one to two years.

There are several moving parts at play in the global energy market, but two have received the greatest focus of late and are arguably the reasons why prices are currently volatile but range-bound. On the one hand is US crude inventories, which broke into record territory several weeks ago and just keep going up and up, and the other is the US rig count, which is rapidly declining as energy producers respond to the pressure of low prices.

On days when weekly US inventory numbers are released we usually see selling, while on days when rig count numbers are released we see buying. But it is the lag between these two which forms the basis of the argument prices must go lower before they go higher.

Oil Market Rigged

One oil rig is not the same as any other oil rig. Some are older, more mechanical, less efficient, and thus less productive than other, newer models. Some are situated in less productive fields than others. It is obvious that if an oil company is forced to curtail production in the face of falling oil prices, the first rigs to be shutdown will be the less productive rigs. These are the rigs most likely to be operating uneconomically at current prices.

On the other side of the coin, newer rigs may also be the first to be shut down if they are operating on a high cost of recovery basis. Shale oil production is the driver of US oversupply, not conventional Gulf production, for example. But while shale oil production costs have come down as technology has improved, it is still a lot cheaper to produce conventional oil. Many shale oil late comers operate rigs that sit high on the cost curve, and are thus uneconomical at current prices.

Thus while the US rig count may be dropping rapidly, the marginal reduction in supply as a result is not a case of simple arithmetic. A halving of the rig count would not, for example, immediately imply a halving of production. Not until energy companies are forced to close down their more efficient rigs would a real dent be put in the supply-side, were it to come to that. Meanwhile, the impact of closing down less efficient rigs will take some time to make any real dent.

Part of the problem is that pretty much all of the marginal shale production in the US is hedged against falls in the oil price. Producers have sold forward their production, meaning they are still effectively receiving old prices, not new. This hedging means producers are not being forced into manically reducing production. They can take their time and hope a price rebound may occur before they are forced to act more dramatically.

Shale producers are not hedged because they saw the fall in oil price coming, nor because they are just very sensible operators. They are hedged because the large proportion of the shale production boom has been funded on debt. Debt is cheap, so why not? Banks have been willing to lend to oil producers, but only with the caveat they hedge their production against the possibility of falling prices.

Smart banks. But they may not look so smart when slowly but surely, these price hedges roll off. They will, of course, have time to address the issue, thus earlier fears of another sub-prime style credit meltdown, this time due to over-geared energy companies, have abated.

The gradual roll-off of hedges will, nevertheless, expedite rig shutdown requirements at the more marginal end of the production spectrum. It is for this reason analysts see an eventual oil price recovery, but not any sharp bounce. A popular expectation is that prices will quietly bottom out in the second half of 2015 before recovering gradually in 2016. But for now, the days of triple digit oil prices are behind us, barring any left of field shocks.

Morgans is one broker subscribing to this outlook. Morgans also points out that when one takes into account the natural rate of global oil field decline, such that production must increase each year anyway just to maintain consistent supply, the apparent surplus created by the shale oil boom is actually not that great at all.

Thus if we add in the drop-off in exploration for new reserves, now occurring due to a lack of price incentive, the gradual recovery story is further underpinned.

Geopolitics

Crude inventory builds and rig counts have been dominating oil market headlines of late, but simmering underneath are ever present geopolitical risks, both potentially negative and positive for oil prices.

Currently in focus are ongoing negotiations between Iran and the West with regard Iran’s nuclear policy. Progress appears to have been made, which implies a lifting of Western sanctions may soon be approved. As promising as such a development might be for world peace, it would mean Iranian oil production will hit the global marketplace meaningfully once more. And Iran does have rather a lot of oil, as well as a need to rebuild its finances post-sanctions.

On the subject of sanctions, Russia remains an enigma. Mr Putin suddenly appeared again after ten days of disappearance, quashing suggestions he may be (a) ill, (b) dead as a result of illness or (c), dead as result of an internal revolt. He’s clearly not dead, but Russia-watchers do not dismiss the possibility of (c) sometime in the future.

The West, and Europe in particular, has been somewhat fortunate in that oil prices have collapsed given it takes threats from Russia to cut off European gas exports out of the equation to a great extent. Sanctions placed on Russia in the wake of the Ukraine crisis initially hit Europe hard as well, particularly Germany, but a combination of the tumbling oil price and ECB stimulus has diminished the impact of those sanctions. But for Russia it’s a double-whammy, given the sanctions are hurting and low oil prices are severely impacting on a Russian economy highly reliant on energy export.

What will Putin do? Well, that remains a great unknown. There is also political upheaval threatening in Venezuela, which is an OPEC member.

Then we have on again, off again production and export from Libya, where each week it seems the taps are turned on before the next warring faction comes along and turns them off again, and a similar situation in Nigeria, where terrorism is also rife and disruptive.

The greatest global terrorist threat of all is of course, IS, whose influence appears to be spreading across the Middle East and Northern Africa. To date IS has not managed to infiltrate the major oil-producing south of Iraq, but nothing is certain.

And the latest geopolitical hot spot is Yemen, where only yesterday the Western-backed president fled the country as militants move in on the capital, Aden. Yemen does not produce oil but sits at the tip of the Horn of Africa, around which a great proportion of seaborne crude is transported from the Persian Gulf en route to the Suez Canal.

OPEC Relents?

It is quite understandable that Saudi Arabia should stand its ground this time around in the face of falling oil prices. Whereas in the past excess OPEC production has often been the driver of lower oil prices, and has elicited production quota cuts from the bloc, this time North America is to blame hence the Saudis have said “You created the problem, you fix it”.

Fair enough. But it’s okay for the Saudis to stand firm and suggest they can withstand even lower oil prices, given Saudi Arabia remains the world’s largest conventional oil producer. More marginal members of OPEC risk their economies being bankrupted if prices remain low for a prolonged period. Prices would quickly snap back if OPEC were to suddenly announce they had changed their minds and production cuts will now ensue.

Then again, OPEC production quotas have always been treated with a deal of scepticism in a global oil market which has long seen OPEC members suggest particular quotas before producing and selling as much oil as they can anyway when prices rise in response to the supposed supply reduction.

Time To Invest?

“While not for the timid,” says Macquarie, “with oil markets expected to rebalance in late 2015/early 2016, we cautiously see well-funded oil price leverage as an attractive opportunity”.

Macquarie sums up the mood across the analyst fraternity with both oil prices, and energy sector share prices, having fallen a long way. Given all discussed above, there are few certainties at play in energy markets at present. But as oil prices begin to stabilise, value among particular energy names begins to become more compelling.

Having already adjusted its energy stock valuations for lower oil price forecasts, Macquarie has recently also lowered its Aussie dollar forecasts over the same period. The lower Aussie provides an earnings offset to low achieved prices, at varying degrees across stocks under coverage.

In the large-cap space, Santos ((STO)) is the greatest beneficiary of the lower currency, Macquarie calculates. Among the mid-caps, Beach Energy ((BPT)), Senex Energy ((SXY)), Drillsearch ((DLS)) and AWE ((AWE)) enjoy the greatest earnings uplift thanks to their high levels of US dollar denominated oil. Those companies reporting in US dollars, being Woodside Petroleum ((WPL)), Oil Search ((OSH)) and Horizon Oil ((HZN)) see a more muted earnings adjustment.

Oil Search nevertheless remains the broker’s stand-out large-cap exposure in the face of lower oil prices, given a robust balance sheet, low capital and operational expenditure burdens and abundant newsflow with regard new well testing and appraisal. Among the mid-caps, AWE and Sino Gas & Energy ((SHE)) are preferred given their exposure to gas.

Australian-listed “losers” from low oil prices, suggests Citi, are those with mature LNG projects, being Woodside, and those exploiting coal seam gas LNG, being Origin Energy ((ORG)) and Santos. “Winners” are those buying Australian domestic gas, being AGL Energy ((AGL)).

On the basis of global LNG supply growth increasing over time to the point of exceeding demand growth, as is Citi’s forecast, the broker suggests those representing the next wave of development will be “winners” but those whose projects are a long way off will be “losers”. Here it comes down to individual projects, given Citi cites Oil Search as a winner for its PNG projects, alongside junior PNG stakeholder Santos, and Santos also a loser for other lesser known projects. Origin is cited as a loser similarly. Woodside’s better-known Browse FLNG project is seen as a loser.

The problem for Santos in PNG is nonetheless that company’s joint venture stake in the Hides Deep prospect and not in the P’Nyang prospect, points out Credit Suisse. With Hides proving full of water, not gas, P’Nyang has firmed as favourite to take PNG LNG to a third train. Santos would only enjoy infrastructure value for T3 if this is the case.

Credit Suisse also has a preference for Oil Search, despite the lack of success at Hides pushing the broker’s expected start-up time for PNG T3 out to 2022.

UBS prefers Santos over Oil Search and then Woodside, given Santos is trading at the greatest discount to valuation based on the current oil price forward curve. The broker admits the company’s balance sheet, and recent departure of the chairman, haven’t improved sentiment towards the stock but on a twelve month outlook, the broker expects to see the successful start-up of Santos’ GLNG facility and the arrival of positive free cash flow by the end of 2015.

Among the mid-caps, UBS has Sell ratings on Beach Energy and Tap Oil ((TAP)) and Neutral ratings on Horizon, Drillsearch and AWE. The broker’s only Buy call in the space is Karoon Gas ((KAR)).

Morgans prefers Oil Search, followed by Woodside. Oil Search’s major PNG LNG development spend has now passed and the first train is now operating at nameplate capacity, boasting the highest operating margins in the sector. Oil Search should now begin to deleverage its balance sheet ahead of its next phase of growth, being the targeted trains two and three. While Morgans believes the market is yet to fully price in Woodside’s upcoming drop in dividend, on the flow-through of lower oil prices, the company still retains a high margin business and almost debt-free balance sheet.

Broker ratings and forecasts for Australia’s major listed energy players are tabulated below.
 

* Earnings swing to positive from negative thus growth cannot be expressed as a percentage

We note that while broker preferences differ, all of Santos, Oil Search and Origin attract five Buy ratings. Santos offers, on forecasts, by far the greatest upside to target as well as the highest yield, yet given its gearing and the yet to start up GLNG, it also offers the highest risk. Oil Search, with PNG LNG underway, is a lower risk proposition but with T2 and T3 in the pipeline, is not a big yield payer. Woodside was the big yield payer, but on lower oil prices and declining production the company will be forced to cut its dividend quantum and that brings its yield back to the pack, equivalent to the two downstream players.
 

 

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