Commodities | Mar 12 2020
Where are the hits and misses from the sell-off in oil likely to materialise?
-US oil producers/explorers experience the greatest equity destruction
-Sell-off in crude oil does not augur well for seaborne thermal coal
-Sell-off in crude stocks an opportunity to accumulate an energy position
By Eva Brocklehurst
As indicated in Part 2 of this series (https://www.fnarena.com/index.php/2020/03/11/opec-pours-oil-on-coronavirus-part-2/), Australian energy stocks are better prepared for the ructions caused by the huge drop in the price of oil as OPEC and Russia square off in their production war. Yet what are the individual global producers facing?
It is evident to many brokers that these oil producing nations have decided to confront the US oil industry, particularly the significant ramp-up in US shale production. As the fallout continues, US oil companies have experienced the greatest equity destruction, with major independent oil stocks now losing around -75% of equity value from their highs.
As background, Shaw and Partners notes OPEC has been cutting production for three years to support oil prices only to have this effect countered by rising US supply from shale. Yet most US onshore oil production, around 13% of global supply, lacks a profit base and has been supported in recent years by financing from junk bonds.
Now equity capital will cease to be a source of funds to service the US$320bn of junk debt that has accrued over the past three years. Capital for development will dissipate and this will hinder future supply growth.
Hence, Citi suspects, with a sustained downturn in the oil price, bankruptcies among the private and some public producers could accelerate. In the short term a large uptake of crude oil into storage is likely.
Macquarie assesses the dramatic sell-off in oil prices could mean a new risk for certain US economic jurisdictions. Texas, the country's key oil state, accounts for around 15% of the US housing market, and when oil sold off in 2015 the impact on employment, and thus housing, was noticeable.
However, this is a more resilient economy in 2020, with only 0.7% of private sector employment in the state directly in oil & gas. While there a number of variables in play and earnings risks are elevated, Macquarie calculates James Hardie's ((JHX)) exposure to Texas is now around 12% of group revenues.
This has been diluted after acquisitions in Europe. Hence, the company stands out as a preference in the US-exposed building segment. Moreover, lower oil prices will help costs. James Hardie has significant underlying fuel cost exposure at around 5% of sales.
Morgan Stanley acknowledges the fresh pressure from OPEC developments and lower oil prices but highlights global expenditure plans were already fragile, given the ear;ier trade tensions.
There are risks that capital expenditure plans are further reduced and projects cancelled but, the broker notes notes, with a lower starting point, stress is mostly confined to operating expenditure or production.
A more severe impact, not one Morgan Stanley currently envisages, is where pressure on upstream cash flow increases and drives a new level of capital discipline that covers more of the tertiary supply chain, particularly as oil & gas represents more than 25% of aggregate capital expenditure in the broker's global model.
Lower oil prices will stymie the growth in US shale production but may take time to play out, Shaw and Partners notes. Shutting in low-cost OPEC supply to boost prices was always going to be an unsustainable strategy anyway.
Oil prices at US$30-35/bbl are not high enough to generate enough supply to meet future demand and Shaw and Partners calculates US$65-75/bbl is required to incentivise supply, the price oil has averaged over the past 20 years.
Oil prices could conceivably fall through US$30/bbl in the short term while, Citi notes, near-term upside requires the OPEC agreement to be revisited along with a return to demand growth. The broker's oil price forecasts now reflect US$43/bbl on average for West Texas Intermediate in 2020 and US$49/bbl in 2021.
LNG & Coal
The sell-off in crude oil does not augur well for seaborne thermal coal, Macquarie points out. A large drop in the price of crude from rising supply usually pulls down gas prices. This reflects a lift in gas byproduct from crude production and substitution in the power sector.
China has now pushed back on cargoes, amid slowing demand, and Macquarie suspects another LNG surplus is in the wings. Europe took most of the 2019 spare LNG but this avenue is now limited. Gas storage also appears relatively full.
One possibility, the broker flags, is more LNG being diverted to northeast Asia but the economic incentives for large-scale switching, as occurred with Europe in 2019, are not there. Supply cuts of LNG are now increasingly likely, perhaps from a scaling back of utilisation in new US projects or from peripheral suppliers. But this is only of marginal value to the coal producers.
Macquarie suspects supply cuts to LNG to balance the market will only happen if gas prices remain near current lows for some time and, in turn, this will prevent any significant upside for thermal coal.
Australian Oil Stocks
Citi observes Australian companies can protect balance sheets by delaying growth expenditure and cutting down on exploration, which is a less dilutive path than raising equity.
Raising equity would only be necessary if growth funding was required immediately, which would then force the market to pay for that growth. The sector is, therefore, either oversold or pricing in distress, and Citi asserts the former is likely to be the case, as most Australian oil companies are well capitalised.
Shaw and Partners urges investors to focus on intrinsic value in domestic equities. Currently, the share prices are at a -40-50% discount to intrinsic value, the steepest in more than 10 years. Stocks that represent the best value in the broker's view are Beach Energy ((BPT)), Oil Search ((OSH)) and Santos ((STO)). On the positive side, markets have short memories and oil prices are cyclical.
Credit Suisse agrees that the recent sell-off is a rare opportunity to accumulate energy positions. Given the uncertainty that still prevails those that have more resistance to lower prices are preferred.
Of the larger names, the broker believes Beach Energy and Woodside Petroleum ((WPL)) provide the most resilience. Strike Energy ((STX)) and Cooper Energy ((COE)), too, as they have sold off too yet provide minimal exposure to oil prices.
Oil Search is considered most at risk, given the possible challenges in meeting its debt repayments if weakness is sustained. Citi assesses the PNG LNG covenants appear solid, unless oil prices dive below US$30/bbl for more than 12 months. Oil Search has US$300m in corporate debt due in September but expects to refinance this via undrawn facilities.
The broker forecasts a temporary breach of Origin Energy's ((ORG)) debt-to-earnings ratio, required for its credit rating. However, the risk of raising more than $1.5bn in new equity if the credit are unavailable is priced into the stock.
In the case of M&A, targets can appear more attractive in terms of valuation but potential bidders may also have limited cash positions. The M&A opportunity could increase if weakness persists over coming months and Credit Suisse considers Oil Search and Strike Energy the more viable targets.
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