Oz Energy Mid-Caps And The Oil Price

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– Uncertainty over oil price direction
– Santos shifts focus
– Mid-Cap partners impacted
– Cooper JV curtailed

By Greg Peel

Has the oil price bottomed?

Morgan Stanley does not believe fundamentals have been the primary factor driving oil prices year to date. MS analysts believe the US dollar and swings in long and short positioning in oil futures contracts (note: the “price of oil” is a futures price) explain much of the price action. When the oil price moves, the market looks for a coincidental explanation.

The most obvious of these is the counteraction of rising US inventories on the one hand, and a falling US rig count on the other. But Morgan Stanley suggests the bounce-back in oil prices is not just a matter of short-covering. Shorts have indeed been covered, but longs have been established as well. Indeed Brent longs are at record levels.

The problem will be if the longs suddenly decide to bail out. Morgan Stanley’s forex analysts believe the recent pullback in the US dollar, which has sustained improved oil prices, will prove but a temporary correction. In which case, look out.

Looking at the fundamentals, nevertheless, Deutsche Bank believes the next step in the normalisation of the crude oil market will commence in the second half of 2015 as floating storage inventories are reduced (oil sitting in moored tankers). The impetus for reduction will be the narrowing of the Brent contango (forward futures curve rising, but not as steeply), which is a disincentive to hold onto oil inventories.

The end of this month will also see many refineries returning from their period of scheduled maintenance, Deutsche notes, which will also lead to shrinking inventories.

NAB analysts acknowledge the role geopolitics has played in the oil price rebound, specifically regarding the battle in Yemen. The country is not itself a major producer of oil but its location at the tip of the Gulf of Arabia, en route to the Suez Canal, suggests threats of supply route disruption. Given tankers can always go the long way round – around Africa instead of through the Suez – the risk of a substantial supply disruption are remote, NAB notes.

NAB puts more stock in the pending reduction in US supply, as implied by the falling rig count. The analysts expect oil prices to remain range-bound around current levels over the June and September quarters given a rig-count-to-supply lag, before kicking ahead towards the end of the year as US supply falls off a cliff.

Whatever the near term direction of the oil price, the reality is lower oil prices have had a profound effect for the outlook on the global oil & gas industry. Particularly in focus are higher cost shale oil developments.

For Australia’s mid-cap oil producers, much attention is focused on the Cooper Basin in South Australia, where a convoluted cooperative exists between energy major Santos ((STO)) and various mid-caps. The cooperative is known as the South Australia Cooper Basin joint venture (SACBJV), although different producers operate under different JV contracts.

On its recent site tour, Santos lowered its capex and production guidance in the Cooper, suggesting the focus will only be to maintain enough production to satisfy the Horizon contract. Credit Suisse doubts investment will ever fully return. In their recent quarterlies, the mid-cap producers all showed production declines and ongoing cash outflows, suggesting the fundamentals are not currently supportive.

The gas growth story does not exist without further investment in the Cooper, Credit Suisse contends, and neither Santos nor Beach Energy ((BPT)) has the capital to commit and even if they did, the economics don’t stack up. A sharp outflow of cash in the quarter has left Beach’s balance sheet looking slim, and while Beach may be considering an infrastructure sale, the combined group may still be beholden to the SACB for gas off-take, the analysts note.

SACB is expected to at least break even in FY16 as capex declines, but Credit Suisse sees few other Beach assets that will drive high returns on capital spent. For exposure to the Cooper’s Western Flank potential, the broker prefers Drillsearch Energy ((DLS)).

Drillsearch offers the best value and boasts the best positioned assets of the mid-caps, Credit Suisse suggests. While having an involvement in the SACB joint venture, Drillsearch stands to benefit from SACB difficulties as Santos looks to diversify outside the JV. The problem is its share price has run hard on this basis.

Another benefactor is Senex Energy ((SXY)) given Santos has renewed its focus at Roma in Queensland. Senex’ share price has run up as a result as well, with the market hoping Senex might be an obvious acquisition choice for the major. Roma is a more nimble operation that is developing cheaper gas than GLNG, Santos has noted. But as Credit Suisse points out, Santos could have targeted Senex long ago, but hasn’t.

Consolidation speculation amongst the mid-caps is rife in the market at present, given the fall in the oil price. In terms of possible targets, Credit Suisse favours Drillsearch over Senex over Beach, but sees limited upside to any of the three.

For its own preferences among Australian oil & gas midcaps, Macquarie is looking beyond the Cooper Basin. Macquarie’s preferences remain AWE Ltd ((AWE)) and Sino Gas & Energy ((SHE)).

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