Oil and Gas: It’s a matter of floor not ceiling

About the author:

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

  • As expected the oil & gas sector is now enjoying a ‘catch up’ rally, as a delayed re-rating to rising oil and gas prices starts to kick in.
  • We see real upside risk to current oil price assumptions, but see increased market confidence in oil’s floor as the greater positive likely to drive a lasting re-rating for sector valuations.
  • ESG remains a key issue impacting supply and supporting commodity prices.
  • We maintain our bullish view on the sector, with Woodside Petroleum (ASX:WPL), Santos Limited (ASX:STO), & Karoon Gas Australia (ASX:KAR) our preferred sector exposures. While also confident in long-term value in Beach Energy (ASX:BPT).

Catch-up rally now unfolding

For the majority of the year oil & gas stocks have underperformed rising oil and gas prices, with a couple of notable de-rating periods. This unnerved investors who were questioning whether a sunset discount had appeared.

We saw the de-rating as more a lack of conviction from local investors rather than any material ESG impact. Oil & gas stocks in more ESG-conscious markets (US/Europe) outperformed our Aussie oil & gas stocks during the same period which supported our view.

What we expect is playing out now is the new multi-year record prices for oil and LNG is starting to penetrate that pessimism and resulting in a ‘catch up’ rally across Australian oil & gas stocks.

Over the last month, WPL share price is +27% (vs oil +13%), STO share price +18% (vs oil +13%) and OSH share price +20% (vs oil +13%). No longer limited by sentiment, and with oil and gas prices still rising, we see a strong outlook for the sector.

Confidence in floor will improve

We think this oil cycle has a long way to go. As expected demand is rushing back while supply has been caught flatfooted.

We attribute this primarily to issues stemming from ESG pressures, namely: 1) increased government interference in some key producing countries, 2) reduced access to capital pushing WACC’s higher, and 3) several global majors looking to exit oil (so poorly positioned to reinvest in supply growth).

While we see the potential for oil prices to rally through US$100/bbl, more important will be the market’s restored confidence in what a typical oil cycle looks like. Which we expect will see Australian oil & gas stocks gradually re-rated.

Oil/LNG forecast upgrade

We have upgraded our forecasts to mark-to-market the recent strength. The biggest changes are coming in spot LNG prices, with JKM pushing north of US$32/mmbtu. We have also upgraded our oil forecasts (summary later in report).

The changes have resulted in sector wide upgrades to our target prices and earnings, to varying degrees depending on market exposures.

Investment view

Amongst the large-caps we maintain our top equal preference for WPL and STO. We view both companies as well positioned as both pursue their own transformative mergers. WPL holds much larger exposure to spot oil and gas prices, while STO boasts a strong diversified earnings mix and investor support.

We maintain an Add rating on both WPL (login to view target price) and STO (login to view target price).

Amongst the small/mid-caps our top pick is KAR, which we maintain an Add rating and (login to view target price). KAR is in the favourable position of being the lone pure oil producer of any scale on the ASX. We think the high-margin barrels it produces will help fund a more than doubling of production as KAR works to rejuvenate the Bauna field.

We pull back our rating on Senex Energy Limited (ASX:SXY) to Hold (from Add), a long-time top sector pick for us but now trading close to fair value after receiving a proposal over a possible takeover offer. SXY’s share price has risen 64% over the last 12 months. Its formidable management and board have done a good job creating and protecting value for shareholders, this remains a confident hold.

We also remain confident on value being on offer in BPT (Add login to view target price) and COE (Add login to view target price). Both less exposed to current spot commodity prices, but both still looking oversold in long-term value terms with attractive upside.

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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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