Sobering Outlook For Oil

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A lower-for-longer oil price is playing out amidst intense competition among exporters to regions with growth. How do Australian energy stocks fare in this world?

-US shale oil economics transforming the way the market views oil
-Strategic deals on oil on the rise with China and India
-Credit Suisse becomes very bearish on Oz oil stocks
 

By Eva Brocklehurst

Energy markets are changing globally. A lower-for-longer oil price is playing out amidst intense jostling among exporters to capture and retain a share of market in the growing regions of the world.

RBC Capital Markets explores the developments in the oil market over the past few years and remains modestly constructive on global oil, of the view that prices will grind higher. Fundamentals are improving but the market has to grapple with increasing supply from the US and producer hedging. The analysts believe the higher and faster prices climb into the end of this year the more pressure they could sustain next year because of this hedging activity.

RBC envisages West Texas Intermediate and Brent will average US$51/bbl and US$53/bbl, respectively, for the rest of 2016 before increasing to US$56.50/bbl and US$59/bbl on average next year.

The recent suggestion by OPEC (Organisation of Petroleum Exporting Countries) of a  pare-back production would mark the first time the cartel has actively sought to cut production since 2008. Moreover, to the analysts it signifies a sharp shift in the policy that was set primarily by Saudi Arabia nearly two years ago, to abandon the cartel's principles in favour of securing market share.

RBC observes that while many in the market have referred to this course of action as the “Saudi market share battle”, the actual growth in production from regional competitors such as Iraq, Russia and Iran suggests the Saudis have not been leading this battle for some time. Rather, the Saudis were dragged into a price war and forced to participate in order to prevent a loss of market share.

Furthermore, the broker asserts that the war being waged in Yemen has wounded Saudi Arabia in fiscal terms, while US shale oil economics have transformed the way the market now thinks about future cycles.

The US has pushed towards energy independence, using its domestic production boom, and now requires fewer imports. Although, to varying degrees, all major oil exporting countries have become casualties of the US energy independence, Canada has been able to grow its exports to the US at the expense of Saudi Arabia, Mexico, Venezuela and other heavy oil exporters.

The analysts suggest the focus has turned increasingly to China from the US as this has become the world's largest growth area for oil in recent years. Yet, Saudi Arabia's influence – it once had a stranglehold on crude imports to China – has waned significantly. Russia has dominated the incremental battle for market share and captured more than a quarter of the growth in Chinese imports.

The majority of countries use price to win share but others, such as Brazil and Venezuela, have captured a portion of this market thanks to strategic oil-for-loan deals with Beijing. RBC observes this trade is favourable for both parties as countries in financially precarious positions receive an injection of capital while China locks in a physical hedge at a relatively advantageous price.

With this as a backdrop there is a scenario – not inconceivable to the analysts — in which China raises its appetite for country credit risk and increases loans to additional, financially precarious, oil-producing countries. Such a development would increase the share of the market set aside for deal obligations and cannibalise the remains of the pie for those that compete primarily on price.

Another example of such strategic arrangements is between the United Arab Emirates, which runs one of the world's largest sovereign wealth funds, and India, where UAE has made significant infrastructure investment over recent decades.

India has been the bright spot for Saudi Arabia as it has consistently represented 20% of the import market in that country, but it too has expressed interest in seeking similar agreements with India. India held strategic discussions with several Gulf nations this year to swap oil for food, as New Delhi's need for energy mirrors a need for food imports in the Middle East.

So, in RBC's summation, global oil balances have achieved a delicate state of equilibrium but the market remains fragile. At the very minimum OPEC is believed to have bought itself a price floor near US$45/bbl, at least until its meeting in November. Adding complexity, the path of US production remains extremely price dependent.

The analysts expect US production will claw its way back to be slightly positive in terms of growth next year. The long-term thesis for a supply-side shock stemming from significant reductions in capital expenditure — leading to a shortage of new projects – remains a possibility.

Still, the analysts believe the market requires evidence that the surplus in global inventories is being ground down before prices can be sustained above US$60/bbl, estimated to happen in late 2017-2018.

What does this future outlook hold for Australian energy stocks? Credit Suisse has downgraded its forecasts for long-term Brent oil price to US$65/bbl from US$70/bbl. The broker does not expect the market to change its view immediately but, with valuations so stretched, cannot support a positive view on the sector. In fact, the broker believes playing the energy sector in Australia has rarely been tougher.

The Australian energy sector appears expensive and this is highlighted by calculating what oil price is implied by the current share price. Credit Suisse calculates that all Australian sector stocks are trading above the average implied by US peers and Woodside Petroleum ((WPL)) and Oil Search ((OSH)), in particular, look expensive.

A great deal of the relative differential to Santos ((STO)) and Origin Energy ((ORG)) can be explained by balance sheet concerns and a lack of certainty regarding some projects, the broker notes.

Credit Suisse has downgraded Santos and Oil Search to join Woodside among the Underperform ratings. The broker locates Origin Energy, Beach Energy ((BPT)) and WorleyParsons ((WOR)) at the top of a lowly rated sector. On operational assumptions Credit Suisse believes the large cap stocks are pricing in oil at US$68/bbl, US$67/bbl, US$61/bbl and US$59/bbl for Woodside, Oil Search, Santos and Origin Energy respectively.

The broker accepts that completely removing exposure to the energy sector is a risk many investors would be unwilling to contemplate but, despite also being uncomfortable about it, remains in inclined to that view.
 

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