Oil and Gas: ESG will crush oil supply before demand

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
05 July 2021, 8:00 AM
Sectors Covered:
Mining, Energy

  • With supply-demand fundamentals improving, oil prices have been steadily rising, while equities have surprisingly and materially under-performed.
  • We see several drivers including: 1) market pessimism towards oil prices holding onto strength, 2) surge in ESG concerns from investors, and 3) company specific factors with several cum major capex or having operational issues recently.
  • We upgrade our oil price forecasts over the short and medium term as our confidence in the outlook improves.
  • In terms of key risks to the oil price we see OPEC+ supply decisions as critical. As they could misjudge demand and inadvertently crush the market.
  • Our key picks remain STO, KAR and SXY.

Supply-demand dynamic shaping up

Our expectation of a ‘sluggish’ supply response from oil producers to rising oil prices is now unfolding, particularly in the US.

Key factors driving this trend include: 1) limited access to capital for US oil producers, 2) lack of oil investment from majors, and 3) OPEC holding its line on supply preserving the still relatively young oil cycle.

ESG a critical supply risk

2021 has seen a material surge in ESG concerns. This is already starting to have an impact on the global oil market, with investors, banks and governments clamping down on oil exploration and production.

This has seen several global energy supermajors announce plans to rapidly divest oil assets (switching into renewables), instances of government intervention inhibiting oil exploration, activist investors voting disruptor directors onto boards of energy majors, a lack of equity market support for oil ventures, and some difficulty in accessing debt markets. These developments are all starting to have a material impact on the outlook and risk profile for oil supply, at a time where global oil capex is already at a 70-year low.

Meanwhile, looking at future oil demand, including all initiatives announced by governments and companies to date, global oil consumption is still expected to grow by circa 10% by 2040.

While the global energy market is clearly in transition, we believe not enough focus is being given to how long it will take to transition. In the meantime, we face surging supply risks against a backdrop of steady aggregate oil consumption.

Sector trailing oil’s rise

Oil & gas equities have materially under-performed the oil price over the last 7 months. An interesting breakdown in their primary sensitivity, but by no means unprecedented. We attribute the breakdown to: 1) equity market not willing to price in recent oil strength, 2) a surge in ESG considerations, and 3) company factors (WPL/STO/OSH all cum major capex and managing dilution risk, BPT reserve downgrades, and COE Sole under-performance).

On a 12-month basis, the two best performing stocks in our coverage universe have been our key small-cap picks KAR (+120%) and SXY (+83%), who have both enjoyed significant uplift in bottom-up fundamentals.

Action

We do not view the under-performance of oil stocks as structural, and as seen in the past we expect equities to ‘catch up’ as the upcycle continues. As a base case we see oil prices well supported by the rapidly changing supply dynamics, which is simultaneously blunting the current required supply response (creating short-term potential for exceptional oil price upside) and eroding the investment needed to avoid future oil market instability. We have upgraded our short-, medium- and long-term forecasts (summary on page 7 in report).

With this view in mind, we maintain an overweight recommendation on energy. Our key picks remain STO (ADD, $8.70 PT), KAR (ADD, $2.10 PT) and SXY (ADD, $4.50 PT). The key risk to our call remains COVID-19, which could further impact demand in the near term. We have upgraded OSH to ADD (from HOLD) on recent weakness and the upgrades to our oil forecasts.

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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