Energy Sector’s Sword Of Damocles

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Jul 26 2017

In this week's Weekly Insights:

-Energy Sector's Sword Of Damocles
-No Weekly Insights Next Week
-The RBA Narrative That Never Was
-Telstra's Long Anticipated Dividend Cut
-Conviction Calls: Citi, Goldman, Macquarie and CS
-June Quarter IPO Review
-2016 - L'Année Extraordinaire
-All-Weather Model Portfolio
-Rudi On TV
-Rudi On Tour

Energy Sector's Sword Of Damocles

By Rudi Filapek-Vandyck, Editor FNArena

There is a valid argument to be made that large parts of the Australian share market are caught inside a sideways-trending channel.

Shares in staple-favourite Wesfarmers ((WES)) have been moving up and down roughly between $45 and $38 since 2013. CommBank ((CBA)) shares' current price level was common back in 2014. In my story from two weeks ago, Rudi's View: Bigger Picture - Trends (published 13th July 2017, see Rudi's Views on website) I argued the Big Four Banks have been trending sideways for almost four years (since late 2013).

I think there is a fair chance Telstra ((TLS)) shares are now carving out a sideways channel between $4.60 and $4.00, depending on the board's decision regarding dividend payouts in the coming years, of course.

It has taken this long, but more and more oil market observers are now succumbing to the realisation that present global oil market dynamics are likely to keep a ceiling on the oil price above US$55/bbl and a bottom below US$45/bbl.

As long as OPEC and Russia remain disciplined, and no major supply disruptions or geopolitical tensions occur, these are the levels at which swing producers in the Permian basin in the USA either thrive or perish, adding more supply or less into a well-supplied global market.

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It is not unthinkable for the global oil market to go through the same scenario over and again: oil price rises, US frackers add more supply; oil price weakens, the highest cost and most price sensitive producers retreat; oil price rises, those swing producers join in again. As long as these dynamics remain in place, and demand stays within reach of supply with and without US marginal producers, it seems but likely the current range can remain in place for a long time.

Now that crude oil futures have again sunk to near the bottom of the price range, fast money is once again positioning for another swing to the upside. This also makes sense in the share market, where Woodside Petroleum ((WPL)) shares, for example, have fallen from $34 in April to below $29 this week.

Over that same period, Oil Search ((OSH)) shares have sunk to $6.51 from $7.60; Santos ((STO)) now trades at $3.19 instead of $3.80; Beach Energy ((BPT)) shares went from $0.80 to $0.55 but they've already bounced back to $0.65.

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Early repercussions from what seems like a fairly stringent regime for global oil, are revealing themselves through analyst updates this month. Oil price seasonality usually implies the oil price peaks in July. This year, the first seven months have put a series of lower tops and lower lows on price charts, showing an underlying down trend from the US$55/bbl recorded at the start of the calendar year.

The result has been for a lower average oil price over the period than most had expected. Research updates on the energy sector in July, without exception, have all led to lowered forecasts, and thus to reduced valuations and price targets. Predictably, this has weighed upon share prices and certainly it has contributed to share price weakness throughout the sector these past three weeks.

Consider, for example, that FNArena's consensus price target for Woodside has fallen to near $30 from almost $33 in circa two months only. For Oil Search, the consensus target has fallen from $8 to $7.49. BHP ((BHP)) has felt the impact too, with its consensus target falling to $27.45.

At the start of the year many were predicting a share price starting with a '3' for the Big Australian.

It has to be noted too, many a quarterly production report released in July failed to excite the market, often disappointing on volumes or costs, which also contributes to cuts in forecasts and less enthusiasm to jump on by traders and sector enthusiasts.

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An interesting new dynamic for sector investors in Australia stems from the divergence in USD priced oil and the surging AUD/USD on the misguided belief the RBA is soon to embark on a tightening course. As such, the stronger Aussie dollar has now become yet another valuation headwind for a sector whose main product sells in USD.

Analysts at Credit Suisse last week put spot oil and AUD/USD through their modeling and resulting valuations for Australia's main energy producers looked quite sobering, to say the least. On Credit Suisse's modeling, fair value for Woodside had sunk to $17.50/share (not a typo), for Oil Search it was $4.15, for Santos ((STO)) $1.90 and for Origin Energy ((ORG)) $4.10.

Of course, these numbers are rubbery by nature, and nobody at this stage is expecting oil to remain steady at current level, nor the Australian dollar to remain near 80c against the greenback, but the broader issue here, argues Credit Suisse, is whether investors should now be paying closer attention to the currency and its possible impact on share price valuations?

It is quite rare for the oil price and the Australian dollar to diverge as much as they did thus far in 2017, but given oil market dynamics, and valid question marks around Fed policy later this year and in 2018, this may not be the last time, or a temporary phenomenon only.

For good measure: Credit Suisse thinks the answer is "yes", oil sector investors should be incorporating AUD/USD into their risk and valuation modeling, and accept it as yet another negative ("valuation headwind") for the sector.

Ironically, point out CS analysts, companies with a lot of debt in USD carry a valuation offset (as the USD burden becomes smaller as the AUD strengthens). Given all of the above, it should come as no surprise Credit Suisse's favourite oil sector exposure is Caltex ((CTX)).

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By far the largest threat to energy sector valuations is represented by long term oil price projections used by analysts to make future projections about cash flows, revenues and project returns, combined circling back into contemporary company valuations.

Short term oil prices can swing heavily, and they do impact on share prices through short term traders and algorithm robots, but large investors take their cue from longer term projections and assumptions. Were they to give up on the prospect of oil prices to break out of their current range in the foreseeable future, this would have significant impact on valuations for energy producers today.

Yet, July has witnessed two teams of sector analysts doing exactly that in Australia.


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