Oil & Gas: Fracs & WACCs

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
13 July 2022, 9:00 AM
Sectors Covered:
Mining, Energy

  • With the oil price hitting a bout of volatility we review our sector assumptions and sector investment thesis.
  • Investors appear nervous on equities that are sensitive to growth. Despite positive fundamentals we caution against the potential for further volatility.
  • Despite buoyant margins in oil, we still see US production growth as remaining lacklustre, driven by persistent investor pushback and service sector constraints. 
  • We see oil prices staying higher in the long term but also an undeniable increase in the cost of capital for the oil and gas sector. We have reviewed our funding assumptions leading to an increase in sector WACCs.
  • We recommend cautious accumulation of our top sector preferences Santos (ASX:STO), Woodside Energy Group (ASX:WDS) and Karoon Energy (ASX:KAR). While more neutral on Beach Energy (ASX:BPT), Cooper Energy (ASX:COE) and Central Petroleum (ASX:CTP) in the short term.

Bout of volatility

Our conviction level on the short-term direction of oil prices is at a 2-year low. This uncertainty is not driven by any breakdown in oil market fundamentals, but rather the risk to prices that can be delivered by faltering sentiment on demand.

We attribute this to market concern around global economic growth, but also uncertainty around China’s ability to defend itself against COVID. Important given we estimate China to account for over half of global oil demand growth in 2022, Chinese growth at 1.7mb/d versus total global oil demand growth of 3.3mb/d.

While the above factors could well dent some 2H22 demand growth expectations we also see there being a reasonable probability that equity markets overreact moving ahead of any further volatility. Which could generate new buying opportunities at more attractive levels.

Flattening our long-term US supply expectations

At the start of the year, we had expected US oil supply to expand ~1.4mb/d and Russian supply growth of ~1.0mb/d in 2022. We have dialled back US growth to ~1.0mb/d while Russian oil output has slid into negative territory following the fallout from the ongoing Ukraine conflict.

Post these changes we now estimate 2022 world oil production of ~100mb/d (+4.6% yoy), vs world oil consumption of 100.5mb/d (+3.4% yoy). Forecasting a narrow deficit, we expect oil price volatility to pick up in the second half of 2022.

Where we have gained conviction is the diminished long-term outlook for oil supply growth, particularly in the US, which we view as having lost its mantle as the oil market’s swing producer. Two once-in-a-decade oil price collapses (2016 and 2020) resulted in what we consider to be a permanent loss of liquidity for the US oil industry.

We base this on what we view as lower available capital from banks (lower sector gearing and drop in reserve-backed lending) and equity investors (with investors demanding better FCF profiles and positive returns).

Changes to assumptions

We have made a number of upgrades to our oil price forecasts. 2022 now US$102/bbl (was US$91/bbl), 2023 now US$89.5/bbl (was US$78/bbl), 2024 now US$78.5/bbl (was US$66/bbl), 2025 now US$68/bbl (was US$62/bbl), 2026 now US$65/bbl (was US$62/bbl), and a new long-term real price assumption of US$ 65/bbl (was US$62/bbl).

While Morgans’ house risk free rate (3.0%) and market risk premium (6.0%) remain unchanged, we have made various changes to energy sector equity betas, cost of debt, and funding mix assumptions.

Investment view

We are cautious on our investment view in the short term given the potential for further volatility. But do believe long-term value is already on offer in the sector.

Our key sector picks remain unchanged, preferring STO, WDS and KAR, while our conviction has increased in Woodside (Login to view target prices, Add rating). Woodside is a key beneficiary of the changes to our assumptions, with its large oil price sensitivity and merger with BHP Petroleum having improved credit metrics offsetting any WACC changes.

Meanwhile in the short term we are more neutral on BPT, COE and CTP.

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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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