Prices Rally But Oil & Gas Volatility Continues

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

-Focus likely  to remain on costs
-Incentives continue in CSG-LNG
-Material pain looming for LNG?
 

By Eva Brocklehurst

Will the higher oil prices seen recently be sustained? What is the outlook subsequently for the LNG market? These are questions brokers are attempting to answer as they evaluate the key stocks in the sector.

UBS observes a trend higher in oil prices since January, driven by continued decline in US production and demand surprising to the upside. The broker warns that there is unlikely to be significant growth investment in the sector. While further declines in US oil output and global oil demand growth are expected, countering this is the likelihood that shut-in production could re-start over coming months.

The broker estimates cash flow break even for the large cap stocks is below US$60/bbl, with Santos ((STO)) at US$47/bbl, Oil Search ((OSH)) at US$25/bbl and Woodside ((WPL)) at US$12/bbl. UBS believes Santos needs oil at or above US$60/bbl to make inroads into its debt levels. The question for the other two is, given LNG revenues will be higher at US$60/bbl oil, will growth projects be approved if oil stays up?

The broker notes both stocks have struggled in recent weeks despite the oil rally and expects the focus is more likely remain on costs for the foreseeable future. Credit Suisse, in a similar vein, was surprised by the announcement by Santos and AWE ((AWE)) to drill a well at Ande Ande Lumut, Indonesia, considering the pressure on capital at Santos, though acknowledges the decision was consistent with AWE's commentary.

Citi is more confident that oil prices have turned and revises its outlook for 2016, with a pronounced recovery expected in the second half. The decline in the oil price since 2014 is finally seen having an impact in reducing capital spending by the oil majors, with sub US$40/bbl oil considered too low to replenish supplies and meet growing demand.

The broker's Brent estimates are upgraded by 9% to US$47/bbl with a longer-term real oil price assumption of US$70/bbl maintained and an Australian dollar forecast of US70c from 2019.

Nonetheless, while expecting the low point in oil prices has occurred, and with a positive outlook, Citi acknowledges weakness remains a heightened risk. The broker recently downgraded Beach Energy ((BPT)) to Sell, level with Oil Search, retaining a Neutral rating on InterOil ((IOC)) with others under coverage retaining Buy ratings.

Santos recently announced GLNG train 2 has started production, further de-risking cash flows. Citi welcomes the news as it shifts the company towards a positive cash flow, mitigating the balance sheet risk to further equity raising. Despite a weak spot LNG price, the CSG to LNG projects still carry incentives to maximise production, given low variable costs, and Citi considers forecasts for LNG production should only be limited by expectations for gas supply.

The broker estimates that if all trains were online, GLNG could produce at 80% of nameplate and Origin Energy's ((ORG)) APLNG at over 90%. The broker re-casts its well-by-well production forecasts for each project, based on both well flow rate outperformance and higher upstream processing capacities being demonstrated. For GLNG the modelling indicates nameplate will be reached by mid 2017 and APLNG in early 2017.

Hence, Citi suspects estimates which assume a long ramp-up profile are likely underestimating the earnings and valuation of Santos. The broker's faster ramp up profiles for both LNG operations increases its earnings forecasts for Santos and Origin by 5.0% and 8.0% respectively in 2017. Citi now believes the economics are compelling to run the LNG projects as hard as possible.

On the other hand, Credit Suisse believes the risks around the LNG market from both spot and re-contracting exposure need to be examined. The broker is unsure where the positive news can come from at this juncture and suspects a period of material pain is looming for the spot market.

Credit Suisse does observe that Woodside stated it was not surprised or worried by the current oversupply in LNG markets. The broker currently models for the company's LNG production to be at a plateau until 2030 and struggles to reconcile what appears to be the company's changed view of the LNG market, given management alluded to an expected deficit and need for additional supply in past presentations.

The broker assesses various scenarios out to 2025 and retains a macro view that LNG markets will be in balance by then and spot prices will return to, effectively, the contract price. In the case of Woodside, UBS observes the share price has materially under performed peers over the past four months.

The broker attributes this to a combination of lack of confidence in the M&A strategy, following the failed attempt to acquire Oil Search, a lack of material growth opportunities and concerns that major shareholder Shell may look to divest.

Hence, Woodside continues to trade with the lowest implied oil price, which UBS believe makes it the best relative investment among the large cap oil stocks. The broker also likes the fact that more than 80% of LNG production is contracted to 2019, with some level of downside protection in the contracts.

In contrast Oil Search performed strongly, but prior to the rally was already factoring in the highest implied oil price, which UBS attributes to an M&A premium following Woodside's approach.

The broker, in downgrading Oil Search to Sell, believed that its premium was unjustified and became increasingly concerned around the state of the global LNG market, which it suspects will remain oversupplied until 2023. In this environment, UBS envisages delays ahead in progressing the company's two LNG growth projects.
 

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