Commodities | Jul 14 2021
While energy might be ‘on the nose' for many investors, all brokers expect rapidly changing supply dynamics, fuelled by an unwillingness to invest in large and expensive projects, is likely to support the sector
-Australian energy sector has significantly underperformed global peers
-Rising oil/LNG prices to drive energy stocks higher
-Sharp valuation discounts expected to close
By Mark Story
Given the long overhang cast by covid, carbon concerns and heightened considerations around ESG investing, it’s hardly surprising that the energy sector, both here and globally, has been regarded as something of a pariah by investors.
While stocks in general are seen as overvalued with prices returning to normal following the worst of the pandemic, the Australian energy sector has been left behind by both the broader market and global peers alike.
The ASX Australian Energy Index (XEJ) has seriously underperformed the US Energy Index to the tune of around -22% since they both collapsed in first quarter FY2020.
Despite being pushed higher on the back of declining oil inventories, Australia’s energy sector has significantly underperformed the oil price over the last seven months. In light of the lingering covid threat, the market has clearly struggled with the notion that oil prices can sustain levels north of US$55/bbl.
The sector-wide de-rating across oil and gas in 2021 saw earnings multiples drop by as much as -30% on average. But while forward earnings continue to strengthen, share prices have continued to tread water.
Environmental considerations aside, what has also taken its toll on equity valuations have been revelations several global energy super-majors, including Shell, Exxon, and Chevron, plan to exit oil completely and pivot further into gas and renewables.
Also taking its toll on sentiment and share prices has been investor uncertainty around major equity raisings. As well as being share price dilutive, it also worries investors that large investments needed to fund carbon-hungry projects have by nature lengthy payback periods.
Value on offer
But despite recent share price rises, and the equity market’s unwillingness to price in recent oil strength, brokers are united in their conclusion that value remains on offer right across the energy sector.
The average price to fair value (P/FV) across Morningstar’s A&NZ coverage has risen from 1.10 at the end of March to 1.15, implying the market is 15% overvalued. By comparison, with constituents trading on an average price to fair value ratio of 0.77 - as the higher spot oil price is yet to be factored into share prices - Morningstar assesses the energy sector as -20% undervalued.
But unlike years past, Morgans does not view the current underperformance of oil stocks as structural. The broker expects equities to re-rate during the second half as numerous short-term factors reverse.
As a base case, Morgans sees oil prices well supported by the rapidly changing supply dynamics, which the broker thinks are also dampening the current required supply response.
The broker suspects this is creating short-term potential for exceptional oil price upside, which means stocks are unlikely to remain at sharp discounts for very long. With this view in mind, Morgans maintains an Overweight recommendation on energy, assuming covid does not further impact demand in the near term.
While Morgans has been bullish on oil’s prospects for a significant rise, the broker remains conservative in its price deck assumptions. Despite the case building for lifting long-term oil price assumptions, the broker has at this stage left its long-term Brent oil price forecast unchanged at US$62/bbl, around 7% above consensus.
All brokers unanimously conclude that the short-term price risk is tilted to the upside as producers hesitate to add capacity to meet the temporary shortfall, knowing the energy transition will limit future demand growth.
Based on strong post-covid recovery in key markets, Citi now expects demand to surpass the record 100.8mbdp set in August 2019 by August this year. As a result, the broker upgrades its Brent oil price forecast for 2021 and 2022 by 4% and 13% to US$71 and US$67/bbl.
With most energy-exposed stocks trading well below fair value, Ord Minnett believes M&A could be the spark for equity performance and remains positive on most stocks in the sector. In Ord Minnett’s view, M&A could be a strong catalyst to close the gap between stock prices and valuations.
Potential M&A scenarios postulated by Ord Minnett include Santos ((STO)) buying Oil Search ((OSH)), Woodside Petroleum ((WPL)) acquiring an additional interest in the North West Shelf joint venture, and Beach Energy ((BPT)) targeting Cooper Energy ((COE)) and others.
Ord Minnett has also upgraded its recommendation on Carnarvon Petroleum ((CVN)) to Buy from Hold based on valuation.