Commodities | Jul 03 2023
This story features WOODSIDE ENERGY GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WDS
New research highlights longer-term existential risks for ASX-listed Oil & Gas companies that need to determine the ‘right’ level of spend for the energy transition.
-Equity values are at risk in the ASX Oil & Gas sector
-M&A activity expected among the juniors
-Macquarie’s picks in the small-mid cap space
-Opportunities in the East Coast gas market
By Mark Woodruff
While the energy transition road may be paved with good intentions, it is also littered with land mines for companies in the Oil & Gas sector.
Brokers see many positive short-and medium-term pricing trends for the sector, yet Citi points out companies like Woodside Energy ((WDS)), Santos ((STO)) and Beach Energy ((BPT))) are all taking on technology and market risks to diversify revenue, and equity value may yet be destroyed.
Citi explains existential risks will become more pronounced courtesy of various stakeholders including lenders, equity investors, disillusioned current and future staff, as well as customers. Also, insurance may become unavailable for certain projects and regulatory risk could persist and become even greater.
The balancing act and desired outcome for ASX energy companies is to be seen to allocate an appropriately high amount of capital to the energy transition to avoid these existential risks from stakeholders, explains the broker.
As ASX-listed oil and gas companies are generally avoiding the pathway to becoming renewables developers, nascent technologies like hydrogen and carbon capture usage and storage (CCUS) are being explored.
While this approach presents risks, the analysts prefer the adoption of these technologies as existing technical capabilities and cultures are better suited to green “molecules” such as hydrogen, ammonia and methanol compared to green “electrons”.
Those companies lacking the scale or corporate culture to transition should try to be acquired, according to Citi. As a result, consolidation amongst juniors and public-to-private M&A is expected to become a trend in the current decade.
Another alternative is to adopt a capital-light corporate structure and enter “harvest mode” by returning all free-cash-flow-to-equity to shareholders until the equity value of the business goes to zero. This approach is recommended by the broker for Beach Energy whose transition strategy leaves a lot to be desired.
New Energy defined
Relevant to the following discussion is Citi’s definition of “New Energy”, which is inclusive of both decarbonisation and diversification.
An example of decarbonisation for energy companies is the powering of grids by a meaningful share of renewables with the aim of reducing Scope 1 and Scope 2 emissions towards net zero in a timely manner. While nobody yet has a firm grip on the right level of spend, the broker encourages companies to target net zero scope 1 and 2 emissions by 2040.
Diversification, explain the analysts, may include alternative fuels such as hydrogen and biodiesel, with the aim of creating new revenue streams not linked to oil/gas prices. Examples include revenue-generating carbon capture solutions like direct air capture (DAC), carbon capture and storage (CCS) or renewables projects like offshore wind.
Not only do energy companies need to direct the ‘right’ amount of capital to New Energy to avoid existential risks from stakeholders, but they also need to develop a range of capabilities, explains the broker. These skills will then allow a timely movement of capital to the most economic technology, while management also juggles capital allocation between capex and capital returns to shareholders.
Unfortunately for the industry, technology risk is not underwritten by subsidies, as the Australian government do not want to be seen as helping the industry, explains Citi, unlike the situation in the US.
Three ASX companies
Buy-rated Santos is currently cheap, in the broker’s view, and its emissions reductions (scope 1 & 2) are considered ambitious and commendable.
While the company’s diversification strategy and emissions reductions come with some technology and market risk, overall, the analysts believe Santos has the best strategy to balance transition risks and is already remunerating key management personnel accordingly.
On the other hand, Neutral-rated Woodside Energy is very reliant on hydrogen at scale to underpin its strategy. This approach takes on market risk such as whether customers support an economic outcome for hydrogen at scale. Alternatively, the technology may be relegated to local and niche applications, given large energy losses across the value chain, explains Citi.
Nonetheless, the company is exploring various other transition options such as concentrated solar and ammonia.
Woodside also has the advantage of a US listing, and should its US$5bn New Energy spend fails to materialise, existential risks from an equity capital perspective may be less intense than for Santos and Beach Energy. This is because US investors have a greater tolerance for oil & gas companies that are not actively positioning for the energy transition.
Citi highlights Beach Energy has no mature New Energy projects, apart from Moomba CCS, and the remuneration policy doesn’t appear to incentivise management to pursue them anyway. Regardless, the valuation is currently very cheap and Citi rates the company a Buy with a $1.65 target.
The global outlook for the Oil & Gas sector
Wilsons sees unparalleled tailwinds for the global Oil & Gas sector due to medium-term demand growth and supply constraints.
The broker holds this view largely based on oil demand in the four most populous developing nations, where growth potential is forecast to be multiples of their current consumption per capita.
By way of example, Wilsons points out 2022 oil barrel consumption/1000 people/day for China, India, Indonesia and Brazil was 11.1, 3.6, 5.6 and 10.9, respectively, whereas in the US and Australia the figures are on average 60 and 45, respectively.
Oil demand is more robust now, explains the broker, as the non-OECD oil consumer currently represents around 55% of global oil consumption compared to 45% twenty years ago. What’s more, this customer has shown no slowdown in oil consumption even when oil prices were at their highest (or inelastic demand, in economic terminology).
Moreover, the analysts note oil supply is constrained as the commodity investment cycle is officially broken and the upstream industry is under-invested by US$1.1trn. Investment in the global oil and gas industry has dropped -26.7% below a balanced market expectation from 2016, which doesn’t include any underinvestment associated with the first half of 2023.
Additionally, unconventional (mainly shale) production in the US no longer adds incremental production and a rapid decline is forecast by Wilsons in the next 12-24 months.
Macquarie’s forecast for the next six to twelve months is for Brent crude oil prices to be range-bound between US$70-80/bbl.
In looking at small-to mid-caps, the analysts prefer companies with low debt and reserve growth and has Outperform ratings for Karoon Energy ((KAR)), Strike Energy ((STX)) and Tamboran Resources ((TBN)).
All three are on the verge of material resource growth and Karoon receives special mention by the analyst for generating strong free cash flow.
The LNG market
In the short term, Wilsons sees a relatively tight LNG market going into the European winter (2023/24) and expect market volatility over the next 6-24 months.
Longer-term, the broker points out the LNG market is still relatively immature. It has a large demand growth runway, largely via rapid growth out of Asia, while there are several significant LNG export projects in the pipeline.
In a five-to-ten-year timeframe, Wilsons anticipates price weakening could occur as these new LNG projects should be able to comfortably supply LNG demand.
Opportunities for small-to mid-caps in the east coast gas market
A structural gas supply deficit exists in the East Coast gas market in Australia, which needs more supply to support residential and commercial demand due to years of underinvestment and barriers to exploration and development, explains Wilsons.
The broker notes the deficit is highlighted by record pricing and unprecedented government intervention to put a lid on prices and provide relief to gas consumers.
A mandatory code of conduct was among several measures announced by the Federal Government in late-2022, which gas producers will be required to follow when negotiating and entering into gas supply agreements in the domestic market. These producers will know within days the final terms when the full mandatory code is released.
Market intervention has exacerbated the issues on the East Coast, created market instability and slowed new projects coming online, according to Wilsons. This has scared away most of the major players in the upstream but is thought to provide potential tailwinds for small-to mid-cap companies.
Smaller companies that produce gas just for the domestic market (under 100 PJ/a) are to be exempted from gas price caps.
Around the world, Wilsons observes such price caps have never been successfully implemented and sustained for long periods of time, which suggests long term gas pricing will be materially higher than the proposed $12/GJ cap, especially given the lack of investment shown by the industry following government intervention.
Jarden forecasts spot gas prices will continue increasing over the course of 2024 and 2025, as the market starts to prioritise gas supplies from Queensland to meet demand in the southern states.
Assuming the $12/GJ price cap is finalised for Queensland LNG producers, the broker expects this gas price (plus transportation costs to move this gas to NSW and Victoria) will see prices move to $14-15/GJ in these markets by 2025.
Beyond this period, prices may increase again if LNG imports enter the market, which will likely set a new price cap of $16-18/GJ, in Jarden’s view.
Regarding Beach Energy, Wilsons recently initiated coverage with an Overweight rating and $2.01 target.
This broker expects material increases in oil and gas production, earnings and free cash flow (FCF) yield over the next three years associated with the commencement of LNG sales in the first half of FY24 via its North West Shelf LNG plant and 60 TJ/d (net) gas production throughput via the Otway gas plant into the East Coast market.
At the same time, this broker initiated coverage on Strike Energy ((STX)) with an Overweight rating and 52c target. Value-accretive appraisal and near-field exploration is expected in the short-term and substantial exploration value is thought to exist in the company’s deep portfolio.
The analyst anticipates material cash flows from maiden production at the 55%-owned Walyering gas field in the Perth Basin and its 100%-owned near-term modular South Erregulla gas field development in the same location.
Wilsons highlights exploration prospects in the Perth Basin are experiencing unprecedented drilling on the back of high success rates and sees potentially material gas volumes will accrue to both Strike Energy and Beach Energy via their respective acreages.
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