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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.

Worldwide, most sector analysts are working off a long term oil price of US$65/bbl. Last week, Citi decided to abandon that anchor and to replace it with a long term oil price forecast of US$55/bbl. Argue the analysts: signs of continuing productivity gains onshore USA have compressed the oil cost-curve. Citi's research concludes the incentive price to meet future demand has now permanently reduced to US$40-60/bbl.

Putting the new long term price forecast through Citi's models caused valuations in Australia to deflate by between -8-23% while profit forecasts fell by between -12-50%. For example, the new price target for Woodside has now become $27.50, from $32.41 before the change, while for Origin Energy the new target of $7.34 compares with $8.59 prior. Oil Search's updated price target is $5.72, down from $7.47.

One day before Citi released its revised energy sector forecasts and valuations, oil sector analysts at JP Morgan/Ord Minnett had come to the same conclusion. Their new long term oil price forecast is also US$55/bbl, down from US$60/bbl prior.

In their research update, JP Morgan/Ord Minnett highlighted why these lower price projections are likely to have major impact on the outlook, and thus valuation, of Woodside Petroleum: "sustained low oil prices have had the effect of not only lowering our estimated value for Woodside, but also potentially delaying or deferring the company's growth projects".

Note the broker remains positive on Oil Search because of corporate appeal while for Origin Energy the emphasis lies with rising gas and electricity prices for the utility part of the business.

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To date, most teams of energy sector analysts continue to work off US$65/bbl longer term. At a recent seminar, leading industry consultant Wood Mackenzie reiterated its view a moderate price recovery for oil remains on the agenda by 2020, when US$65/bbl should be back on the agenda.

Shorter term, the second half of 2017 should see a bounce in the oil price, while consensus is converging around global over-supply in 2018. The major risk for investors in the sector does not come from marginal surprises in timing and volumes, or from daily volatility which makes perfect timing difficult, but from the fact that more analysts might join the conclusion that US$55/bbl is now likely the new anchor, long term, for a sector already struggling to cope with ever changing dynamics.

This, I believe, has now become a permanent Sword of Damocles(*) hovering above sector share prices.

The importance of all this was once again highlighted in that recent sector update by Citi with the analysts calculating today's share price of Woodside Petroleum represents an oil price average of US$68/bbl. Same for Oil Search. For Origin Energy and Senex Energy ((SXY)) the price seems to have incorporated US$55/bbl. That drops to US$40/bbl for Santos, but then Santos comes with a sharply higher risk profile and investors have priced in a hefty valuation discount in response.

Interestingly, stockbroker Morgans points out Santos's most attractive asset, PNG LNG, will require hefty investment in years to come. This might force the company's hand to put the asset up for sale. While the share market might greet such announcement with great joy in the short term, it goes without saying this would be a major negative for the company's outlook longer term.

Bottom line: crude oil prices remaining range-bound for a prolonged time significantly increases the risk profile for investment opportunities in the sector, with capitulation by financial analysts on the long term price average representing a tangible threat.

Investors should adjust their strategy and exposure accordingly.

[(*) According to the legend, Damocles was a servile courtier to King Dionysius I of Syracuse. The king, weary of Damocles' obsequious flattery, invited him to a banquet and seated him under a sword hung by a single hair, so as to point out to him the precariousness of his position.]

No Weekly Insights Next Week

Next week I'll be visiting Queensland's Surfers Paradise to attend the Australian Investors' Association's (AIA) national conference. The AIA was established in 1991 but I believe this year's conference will be their 25th, so there's reason for celebration.

In case you are attending, I'll be guest moderator for the big debate on Monday evening, "That Trading is more profitable than Investing". I shall also be at the book stand with a few copies for sale, with or without author's signature.

For regular readers of Weekly Insights, my presence at the conference means there will be no edition to look out for next week. I intend to dedicate Weekly Insights the following week (August 7th) to a preview on the upcoming reporting season. Should be interesting.

The RBA Narrative That Never Was

It has been quite the surprising experience to witness how easily economists, journalists and market commentators joined the (misguided) narrative that central banks around the world were about to move in tightening mode.

No surprise thus, central bankers around the world have swiftly brought out their fire extinguishers to temper whatever was trying to catch fire inside financial markets. Folks, if you ever wanted to see how mass-delusion can temporarily get a solid grip on the public mindset, the past few weeks have been an excellent example.

There is no tightening going on. Even in the USA, where the Federal Reserve is arguably the most advanced in abandoning exceptional monetary stimulus, Yellen & Co are still a long way off from actual "tightening". I've said and written this before, but moving away from extreme stimulus to less extreme stimulus is not the same as "tightening".

Serious questions are being asked, in the USA and elsewhere, about how many more actual rate hikes remain on the agenda once the Fed starts shrinking its multi-gazillion dollars balance sheet, probably in October, which explains why the US dollar has been so weak this month.

Closer to home, they must have had a collective stroke inside the RBA building on Martin Place, Sydney with journos at the Australian Financial Review, commentators on Sky Business and even the Prime Minister himself talking up the prospect of much higher interest rates, and soon.

Hence why RBA Deputy Governor Guy Debelle's speech was timely and important on Friday last. As expected, by yours truly (not sure if there were many others), Debelle did his best to counter the public narrative that the RBA had been preparing the Australian populace for higher interest rates.

The two most striking, and unambiguous, statements made by Debelle on Friday concerned the fact that other central banks offshore might be getting ready to raise interest rates, but this by no means automatically implies the RBA has to follow in their footsteps. The second one related to the inclusion of the RBA board's discussion about what today's neutral setting in terms of cash rate might be. That was just a theoretical discussion, declared the Deputy Governor, not a hint to financial markets.

On the day the RBA published its June board meeting minutes, I tweeted they were about to learns some key lessons about how best to communicate on Martin Place. I still think that's a fair conclusion. Why put it in otherwise?, I heard commentators and FX traders ask since. Let's just say the RBA had something else in mind, a signal that "neutral" today is not the neutral we all know from way back when.

It hadn't crossed their mind that everybody would be running with the narrative about eight hikes to follow instead.

I recently wrote an in-depth assessment of what exactly is happening in bond markets, and why investors are being forced to pay attention. Paid subscribers can access this story, Rudi's View: My Name Is Bond, via Rudi's Views on the website, or simply via the following link: https://www.fnarena.com/index.php/2017/07/07/rudis-view-my-name-is-bond/

Also note: my book "Change. Investing in a low growth world", published in 2015 still qualifies as a valid reference point for what remains today's context and background for investors and central bankers around the globe. Change is available through Amazon and other online channels. It is included as a free bonus for everyone who joins FNArena as a paying subscriber.

Bottom line: Melbourne Cup rate hike in November? Dream on. But equally: not sure about another rate cut in 2018 either. This RBA might be leaving the cash rate unchanged for a long while.

Telstra's Long Anticipated Dividend Cut

The FNArena Sentiment Indicator is one handy tool for investors looking what kind of yield is available in today's share market. You press the button "High Dividend" and out come the names, highest yields first.

As such, I can report the current Top Five in Australia comprises of:

1. Crown Resorts ((CWN)) offering 9.45%
2. Cromwell Property ((CMW)) offering 8.92%
3. Fortescue Metals ((FMG)) offering 8.58%
4. Harvey Norman ((HVN)) offering 7.97%
5. Telstra ((TLS)) offering 7.57%

This is where the standard warning "Buyer Beware" applies. The share market does not provide free lunches. Questions must be asked as to why these stocks offer such high yields when others like, say, Tatts ((TTS)) and APA Group ((APA)), offer circa 5% only?

In case of Telstra, the answer is simple: investors have been preparing for the inevitable reduction in dividends, now expected for next financial year (FY18). But how much of a reduction is feasible and how much further should the share price fall to reflect this?

We can but hope the board will provide all the answers when the telco reports in August, because too much uncertainty can upset even the most loyal shareholders if it lasts long enough. However, having paid close attention to all the assessments made by stockbroking analysts in the weeks and months past, it would appear the most bearish are willing to settle for an annual payout of 25c from FY18 onwards.

In yield terms, this translates into 6.22% at Monday's share price level of $4.10. According to FNArena's Sentiment Indicator, this still places Telstra shares on position number 14, behind ERM Power's ((EPW)) 6.49% but before Stockland's ((SGP)) 6.21%. In other words: even on reduced dividends, Telstra's yield shall remain among the juiciest in the domestic share market.

I think this also answers the question about how much further the share price should fall post the event. I think the share price might actually rise once the dividend cut announcement has been made, assuming there's no additional negative news that accompanies it.

Conviction Calls: Citi, Goldman, Macquarie and CS

Citi analysts removed MYOB ((MYO)) from their Focus List Australia/NZ, which captures their best "conviction" ideas across all sectors and segments of the Australian share market. It appears the analysts haven't abandoned their positive premise for the accountancy software supplier, it's just that private equity shareholder Bain Capital, still sitting on 40% of MYOB equity, might be looking at offloading the shares and investors won't be rushing in in the meantime.

MYOB has been replaced with ALS Ltd ((ALQ)). Citi has drawn additional optimism from the company's recent market update and believes superior returns are definitely a possibility for those who own the shares.

The Citi Focus List Australia/NZ currently consists of the following constituents: ALS Ltd, Aristocrat Lesiure ((ALL)), Caltex Australia ((CTX)), Qantas ((QAN)), NextDC ((NXT)), Santos ((STO)), Sims Metal ((SGM)), Stockland ((SGP)) and Star Entertainment ((SGR)).

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Analysts at Goldman Sachs have also been making a number of adjustments to their Conviction List Australia/New Zealand. According to the most recent update, that list now comprises of: Graincorp ((GNC)), Newcrest Mining ((NCM)), Sims Metal ((SGM)), Sky City Entertainment ((SKC)), Oil Search ((OSH)), ANZ Bank ((ANZ)), Lend Lease ((LLC)), Lifestyle Communities ((LIC)), Property Link Group ((PLG)) and Sydney Airport ((SYD)).

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Analysts responsible for Macquarie's model portfolio have taken the view that consumer spending might be weak in Australia, and the outlook remains weak, but investors should not price in a total collapse. As such, Macquarie's Recommended Australia Portfolio has upped the exposure to JB Hi-Fi ((JBH)), as well as to Westfield ((WFD)), to Vicinity Centres ((VCX)), to Transurban ((TCL)) and to the banks. Lend Lease has been removed from the portfolio.

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Market strategists at Credit Suisse are keeping the faith in a broadening earnings recovery alongside rising bond yields. Their Strategy Long-Short Ideas currently consist of the following inclusions:

Long Ideas (higher share prices expected): ANZ Bank, BHP ((BHP)), Rio Tinto ((RIO)), Fortescue Metals ((FMG)), AMP ((AMP)), South32 ((S32)), Caltex, BlueScope Steel ((BSL)), Star Entertainment, Adelaide Brighton ((ABC)), Nine Entertainment ((NEC)) and Eclipx ((ECX)).

Short Ideas (lower share prices expected): ASX ((ASX)), APA Group ((APA)), Cochlear ((COH)), Healthscope ((HSO)) and Charter Hall Group ((CHC)).

Note to paying subscribers: all Weekly Insights updates since early February this year have included updates on Conviction Calls, with the sole exception of the July 3 edition. See Rudi's Views on the FNArena website to access the archive of past updates.

June Quarter IPO Review

The June Quarter IPO Review is out, published in cooperation with OnMarket BookBuilds:

https://www.fnarena.com/index.php/2017/07/17/ipos-increase-dramatically/

2016 – L'Année Extraordinaire

It was quite the exceptional year, 2016, and I did grab the opportunity to write down my observations and offer investors today the opportunity to look back, relive the moments and draw some hard conclusions about investing in the world today.

If you are a paid subscriber to FNArena, and you still haven't downloaded your copy, all you have to do is visit the website, look up "Special Reports" and download your very own copy of "Who's Afraid Of The Big Bad Bear. Chronicles of 2016, A Veritable Year Extraordinaire" (in PDF).

For all others who still haven't been convinced, eBook copies are for sale on Amazon and many other online channels. You'll have to visit a foreign Amazon website to also find the print book version.
 

All-Weather Model Portfolio

In partnership with Queensland based Vested Equities, FNArena manages an All-Weather Model Portfolio based upon my post-GFC research. The idea is to offer diversification away from banks and resources stocks which are so dominant in Australia, while also providing ongoing real time evidence into the validity of my research into All-Weather Performers.

This All-Weather Model Portfolio is available through Self-Managed Accounts (SMAs) on the Praemium platform. For more info: info@fnarena.com

Rudi On TV

This week my appearances on the Sky Business channel are scheduled as follows:

-Tuesday, 11.15am Skype-link to discuss broker calls
-Thursday, from noon-2pm
-Thursday, between 7-8pm on Switzer TV
-Friday, 11.15am Skype-link to discuss broker calls

Rudi On Tour

– I shall be participating as debate monitor at the upcoming National Conference of the Australian Investors Association (AIA) at the Marriott, Surfers Paradise, 30 July-2 August

– I will be presenting in Adelaide on November 14th to members of Australian Investors Association and other investors, 7pm on November 14th inside the Fullarton Community Centre, 411 Fullarton Rd, Fullarton. Title of presentation: Investing In A Slow Growing World – An Update

(This story was written on Monday 24th July, 2017. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $380 for twelve months or $210 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): http://www.fnarena.com/index2.cfm?type=dsp_signup

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