Robust Demand Pushes Oil, Gas Prices

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The decision by OPEC and allies to continue limiting production until the end of 2018 has provoked a review of the outlook for oil and, by association, Australian gas prices.

-Oil market rapidly re-balancing despite OPEC decision amid little project expansion, except in US
-A key factor in the outlook is the speed at which the US gears up for LNG exports
-Recent easing of Oz gas prices likely to be temporary amid heightened appetite for gas

By Eva Brocklehurst

As widely expected, OPEC and allies have extended their current crude oil output agreement to the end of 2018. Morgan Stanley considers this a positive step forward as it reduces the risk of upside surprises to production, given the inclusion of both Libya and Nigeria in the quota.

The broker forecasts very little growth from OPEC next year with production in Venezuela, Angola and Algeria also likely to decline independent of OPEC policy. The decision comes against a backdrop where the oil market is already rebalancing and inventories have been drawn down rapidly.

With globally synchronous economic growth and oil prices well below historical highs, Morgan Stanley expects demand will continue to power ahead in 2018, and forecasts another year of 1.5mb/d growth. In the absence of an uptick in investment, the broker expects global production decline to continue, modelling a further contraction of 0.1mb/d in 2018.

This leaves an opportunity for the US to fill the gap but for this to happen, US shale will need to contribute at least 1.1mb/d of global growth in 2018, almost a 20% increase. Even so, this will leave the oil market under-supplied by an amount similar to 2017.

Oil prices have risen faster than National Australia Bank analysts expected, with Brent now above US$63/bbl. This should present upside to domestic prices, compounded by forecasts for a lower Australian dollar. Meanwhile, the performance of Queensland coal seam gas has been patchy and new development is likely to be relatively high cost.

The analysts suspect that even if the Commonwealth can create a surplus in the domestic market and keep prices lower than export benchmarks until 2019, it is likely that 2020 is will mean renewed international integration and gas prices will continue to equal export prices, minus transport costs. The key factor may well be the speed with which the US gears up for LNG exports.

The analysts suggest if east Asian prices move away from oil and towards Henry Hub, then there may be downward pressure on Australian export prices.

UBS presents a base case that OECD inventories will reach five-year averages by the September quarter of 2018 after which there will be have a tapering of producer quotas. The broker retains a longer-term view of Brent at US$70/bbl, a level which is estimated to incentivise new production.

The broker increases estimates for 2018 Brent by US$5/bbl to US$60/bbl, which has material implications for company earnings in that year. Higher oil prices also flow into higher contracted LNG pricing. Companies with higher-than-optimal debt levels such as Santos ((STO)), Origin Energy ((ORG)) and to a lesser degree Oil Search ((OSH)), should be able to accelerate a reduction in debt. No acceleration in growth activities is expected.

Shaw and Partners also revises oil estimates higher, in line with current moves in the market, and considers the recent easing of gas prices a temporary reprieve. Corporate activity is on the ascendancy which means industry appetite for gas is heightened. Oil markets, if OPEC adheres to its cuts, are expected to continue rebalancing through 2018 and gather momentum in 2019.

The broker also notes recent drawdowns in the US and OECD are counter-seasonal and, if sustained, would be quite bullish for oil prices in 2018. The broker revises earnings and valuations for oil stocks across the board and prefers the lower cost, lower-geared stocks which offer the least risk through the cycle.

Supply, rather than demand, is considered the key driver of the rebalancing story. Traders are keenly watching US supply and data shows the US rig count plateauing. US production is now at a record high and benefiting from the diversion of capital to short-cycle onshore US production.

Yet, despite rising domestic supply, US inventories are falling at greater than historical rates, which can only be explained by exports. This suggests that US volumes are displacing supply from other regions where depletion rates are rising.

The question Shaw and Partners asks is: when will debt and equity providers exhaust the funds for this negative investment in US production? A lot of onshore companies remain in negative cash flow and can only continue growing if there is capital to feed on.

LNG Outlook

UBS believes a new wave of supply will be difficult to absorb in the short term. Yet, underlying demand remains strong and a shortage of new projects being sanctioned is evidence the market will eventually rebalance. The broker also suggests LNG pricing cannot change in such a way as to dissuade new investment, which will need to be actioned in the next 2-3 years.

Australian large cap energy stocks are primarily LNG companies so a change in LNG demand growth, likely emanating from China, should mean a faster rebalancing and that this segment outperforms the market over the next 12 months.

While the intensity of reports on Australia's gas crisis have abated, longer-term supply issues have not been resolved, Shaw and Partners asserts, and higher prices are expected to return again in 2018. The broker suggests the industry is responding to gas price signals and the ongoing threat of Commonwealth intervention, with many raising equity capital and activity levels picking up in the Cooper Basin in Queensland.

While major pipelines have been proposed to connect the Northern Territory and Queensland's Bowen and Galilee basins to the east coast network, this will take time. Meanwhile, non-binding approaches to acquire AWE ((AWE)) and Santos suggest ongoing interest in companies which are active in gas exploration and production.

Macquarie envisages the global oversupply from projects that are operating, or under construction, could last until 2022. If advanced projects are included in this calculation the oversupply would extend to 2027. Moreover, two other factors may stretch this out even further, such as export plants running above nameplate and the rise of renewables.

The broker notes significant contributions to volatility in LNG prices have stemmed from the lack of storage capacity in China and start-up delays from new projects. This volatility is now diminishing as gas storage in China has been completed and many of the delayed projects are ramping up in the US and Australia.

In combination with a substantial volume of legacy contracts that are up for renewal, Macquarie has lowered long-term LNG price estimates to around US$7.50/mmbtu in real terms. The broker envisages new demand to 2030 coming through emerging countries in Asia.

The broker's top pick among LNG producers is Oil Search, which has upside from its recent Alaskan acquisition. For Woodside Petroleum ((WPL)) Macquarie believes falling oil volumes in 2018 and rising contract risk do not justify implied pricing.

Wholesale LNG Markets

National Australia Bank analysts observe that domestic gas suppliers are offering wholesale contracts at up to $10/GJ, amid expectations of a recovery in LNG export prices, which are currently hovering around $8-9/GJ. Contracts have become difficult to secure for more than 18 months or so, despite much longer-term contracts being available to overseas importers of Australian LNG.

Domestic spot prices may have trended lower since the June quarter to reflect the move towards more accurate netback prices – exports minus liquefaction and pipeline costs – as well as political pressure, but the summer remains a risk for Australian prices and possibly supply. The analysts expect, if export prices move higher following oil, domestic prices could again exceed $8/GJ and elevated electricity use could drive prices even higher than that.

While Australian LNG exports continue to ramp up, the analysts suspect that some terminals will run well below nameplate capacity. Australian Energy Market data shows that only APLNG is running close to capacity.

Gas used in electricity generation has fallen markedly in Queensland since early 2015 and the beginning of gas exports. In contrast, gas use has increased in Victoria and South Australia since 2016, reflecting the closure of coal generators.

The NAB analysts suggest the implications for energy markets are profound: higher wholesale gas prices will drive improved profitability for remaining coal-fired generators and keep them in service for longer while any new generators are likely to be renewable.

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