The Fallout From OPEC

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

-OPEC challenges US shale producers
-Low oil positive for inflation
-But higher cost producers suffer
-Cash flow needed to stay the course
 

By Eva Brocklehurst

The Organisation of Petroleum Exporting Countries (OPEC) has thrown cold water on oil company aspirations. The meeting of the 12 member cartel on November 28 decided to forgo a cut to production, signalling their game of bluff with the US will continue. The consequences of the decision, or lack of production restraint, are far reaching. Citi's commodity team believes oil prices could find a new US$70-90 equilibrium in the years ahead. 

Citi finds no evidence the group has recognised the new "shale tinged" reality. The UAE oil minister was quoted as saying that US shale producers are the cause of the oversupply and this is not an OPEC problem. The cartel needed a reduction to its production target that would be big enough to balance the oil market but also be viewed as a credible response, and decided to stay its hand. The motives of Saudi Arabia, OPEC's biggest producer, will be subject to debate over coming months. Some of the concerns Citi throws into the whirlpool include the kingdom's preoccupation with succession politics, leaving it hamstrung, and a probable desire to test US production depth while the Sauidis have significant foreign reserves in the bank.

UBS considers the news has clear negative implications for oil, condensate, LPG and LNG producers. All Australian LNG production is linked to the oil price. The broker awaits news on capex reductions by the global majors, which should start happening in early December, believing OPEC is sending a signal that the quickest way to restore equilibrium is for marginal oil producers to slow their investment. This is clearly aimed at US shale producers. Any pullback in their capex plans should be the first signal for lower non-OPEC oil output, at least in the medium term.

On the positive side, global economic growth will get a boost from lower oil prices and inflation will fall, so various central banks' monetary policies will stay looser for longer. This should support global equities and risk assets in general, in Citi's view. On the downside, large oil producers such as Brazil and Norway could do relatively poorly when oil prices fall. Japan, a large net oil importer, should benefit. Citi suspects the decline may be a game changer for Japan's long suffering economy. Yet, weaker oil prices are unambiguously deflationary and could lead to easing of rates in Japan. Global energy stocks will be the obvious losers, in Citi's opinion.

The OPEC decision ends a year which has witnessed a sudden severe slump in oil prices since mid year, with Brent down 36% from its US$116/barrel peak. Even for a commodity known for its volatility, this is significant. Citi is bearish on the medium term and this is mainly because of the US shale gas revolution and growing supply of oil from North America. Global demand, the other side of the oil argument, has been weak. Even with geopolitical risks that traditionally push oil higher, the usual spikes have been missing this year.

Citi expects more pain will be forthcoming across the oil producing world and it may require West Texas Intermediate prices in the US$50/bbl range before OPEC acts. Given the risks are more to the downside, Citi's economists have pushed back their forecasts for the timing of the first US rate increase to December 2015, and have moderated the pace of rate increases expected. Nevertheless, the broker suspects the drop in the oil price is more about supply than demand and a demand-related drop would be the more troublesome for oil equities.

Few companies are prepared for the downside, in Morgan Stanley's opinion. The real issue is whether the low oil prices change corporate behaviour. At any rate, diminishing cash flows will need to be prioritised. Among Australia's oil majors, those with low costs operations and strong balance sheets will outperform.

Woodside Petroleum ((WPL)) is the lowest cost producer, breaking even at US$37/bbl on 2015 and 2016 profit estimates and remains the best placed to endure low prices and potentially acquire cheap assets. Oil Search ((OSH))  is next on Morgan Stanley's list, with break-even of US$45/bbl and no major capital commitments looming until 2017. Santos ((STO))  is the highest cost producer of the three with break-even of US$56/bbl in 2015 and rising to US$62/bbl when GLNG is fully operational. Morgan Stanley believes maintenance of the company's current dividend becomes challenging in this environment and, while a hybrid has been flagged, it may become very expensive.

JP Morgan envisages three potential positives from the fall in the oil price – acquisition targets for Woodside will be cheaper, the appetite for oil-linked LNG contracts may improve and lower oil prices should stimulate more demand. Credit Suisse believes the stand-out name in the sector is Oil Search, although acknowledges the stock could become cheaper. The broker believes the outlook for Santos and Origin Energy ((ORG)) is ugly. UBS believes Santos is the most sensitive to the oil price and also prefers Oil Search ahead of Woodside. Oil Search is over its capex hump while Woodside's dividend is likely to be lower. Among small caps the broker considers Drillsearch ((DLS)) is undervalued while Karoon Gas ((KAR)) is for those with risk appetite.

Small producers in general look unattractive to Morgan Stanley at low oil prices, given that most of them re-invest revenue to maintain or grow reserves. Their ability to do so diminishes with low oil prices as does the investment case. Those with significant debt face critical survival issues, in the broker's opinion. Goldman Sachs adjusts small cap player targets in light of the heightened oil market risks. The broker retains Buy ratings on Drillsearch and Karoon Gas with Neutral ratings for AWE ((AWE)), Beach Energy ((BPT)) and Senex Energy ((SXY)).
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms