It is a fact not often highlighted by investors in energy and mining stocks, but financial market participants tend to treat producers of crude oil and natural gas more favourably than they do mining stocks.
The difference between the two is, of course, crude oil markets have in OPEC one motivated collective of organised producers whose strategy consists of retaining market share and fending off alternatives, when times are good, and providing support to the price of a barrel of crude when times are tough.
As such, one seldom witnesses share prices of energy producers incorporating bottom low oil prices when global corrections hit, but they do on occasion fly even higher than seems justified by crude oil futures and their term structure (gap between short term and longer term futures contracts).
Yet, few investors would have expected share prices of Woodside Petroleum ((WPL)), Origin Energy ((ORG)) and Beach Petroleum ((BPT)) not only to not keep pace with surging oil prices at the start of new calendar year 2018, but also to significantly underperform the broader share market in Q1, a time when broader indices seldom managed to reach into positive territory year-to-date.
It wasn't even a domestic anomaly with share prices of global leaders for the sector -think Royal Dutch Shell in Europe, BP in the UK and ExxonMobil in the USA- all displaying the same obvious dip from peak share prices in late 2017. So what's been happening?
The secret, so to speak, is probably related to the fact that ever since oil price futures crashed below US$40 per barrel in H1 of 2016, share market investors have remained confident this would not remain a permanent feature for the sector overall, and prices would recover from such low level.
As a result, share prices in most energy producers, ex company specific balance sheet issues, have roughly priced in a US$10/bbl premium vis-a-vis where crude oil futures have been trading since that last crash more than two years ago.
Ignoring the constantly widening and closing gap between the various global benchmarks for the time being, when WTI futures were priced at US$50/bbl, local share prices were reflecting oil priced above US$60/bbl, and when WTI futures were surging above US$60/bbl those share prices were reflecting US$70/bbl and beyond.
The problem with this set-up is that, at some stage, this premium needs to be resolved. And it now appears the correction that was overdue/necessary has taken place in the opening months of calendar 2018 with the oil price showing far more resilience than share prices in equity markets, recently surging to a new three year high.
WTI is now priced in the high US$60 region, with Brent in the low US$70s, while most share prices are inferring low to mid-US$60s. No wonder we have witnessed a resumption of the direct relationship between the trend in oil futures and share prices for energy producers.
Given the slight discount that is now implied in many a share price, oil producers' share prices might prove a little more resilient when/if oil prices retreat to lower levels again, or might rally more than seems justified by face value movement in the futures markets.
An important factor will be market confidence. There have been times in recent years when share prices proved more resilient, because investors did not believe low oil prices would remain that low for long. But there have also been times when share prices underperformed and that was sometimes because the share market correctly anticipated a retreat in the price of oil was due.
Late last year, I believe, savvy investors were willing to play upward momentum in global economic synchronicity, but they did not believe oil prices could move as high as US$80/bbl; or stay there if they unexpectedly did. At the time, WTI was trading in the mid-US$60s and Brent was priced above US$70/bbl.
Over the past four months, however, global oil markets have tightened on what may well be this year's perfect storm of collapsing output in Venezuela, infrastructure and financial constraints among shale producers in the USA, and a significant spike in geopolitical tension affecting Russia, Iran and Saudi Arabia; all major producers of crude oil and/or natural gas.
It implies share market investors were wrong in de-rating energy producers, or at the very least they have been too early, with just about every forecaster and market watcher admitting overall risk remains to the upside. Can oil prices reach as high as US$80/bbl this time? Sure they can! Can they stay there? We'll have to wait and see.
A widely adhered to conspiracy theory, one I have voiced myself on numerous occasions, is that Saudi Arabia is still preparing for the largest IPO in history through listing shares in currently fully state-owned Saudi Aramco, and the country's royal family has so much to gain from a supportive oil price in the lead-up to this milestone event, they will make damn sure oil shall be priced expensively, not dirt cheap during the process.
Aramco is the largest oil producer in the world. Investment bankers have been working on this deal for at least two years now and recent indications are the scheduling has moved further out, probably into calendar 2019.
In the meantime, the two largest economies in the Asian region, China and Japan, have substantially increased their appetite for natural gas, potentially fundamentally changing the outlook for a commodity that was believed to be heading for over-supply as recent as last year. China has been adopting greener energy policies more stringently than observers were expecting, while Japan seems to have given up on reinstating its prior high reliance on uranium-fed power stations.
The good news from all of the above is share prices no longer need to incorporate an oil price of US$90/bbl or higher to fully participate in crude oil's perfect storm momentum. If anything, shares in Woodside Petroleum, Origin Energy and Senex Energy ((SXY)) retain some extra rally potential with Citi analysts estimating their share prices last week were only inferring oil priced at US$60/bbl, US$41/bbl and US$62/bbl respectively.
Here two additional observations need to be made: firstly, as these producers have assets in Australia, the AUD/USD cross can become of major influence in what is or isn't implied in domestic share prices. Thus far the currency isn't commanding a prominent role. A weakening AUD would certainly add to the short term earnings growth momentum, but with oil surging higher and the RBA sitting pretty doing nothing, here too the risk seems to the upside.
A second matter of consideration is that while share prices in the short term might want to track oil prices, longer term analyst valuation models are based upon a long-term oil price forecast. Either way, the best way to leverage against positive momentum for oil markets is by seeking out individual companies that have a rising production outlook (Oil Search) or whose balance sheet repair improves substantially in the current environment (Origin Energy).
Investors should also note BHP too is a major energy producer, while Santos' ((STO)) share price is now tied to whether suitor Harbour Energy receives the green light for a leveraged full take-over, or not. (The market doesn't think so).
Lastly, shares in energy producers have a rather checkered track record post the global bubble that burst so painfully back in mid 2008. It almost sounds inconceivable today, but at that time Woodside Petroleum shares, to name one prominent example, had surged past US$70. They are still a way off from the half-way mark today, a little less than ten years later.
Further adding to the dismal picture that remains for all to see on today's historic price charts, today's share price is not even that much higher from the low point of 2016, while leaving little in the pockets of loyal shareholders on a three, five or even seven year backward looking timeline. If it wasn't for the fact that Woodside is actually a rather generous payer of dividends...
The example of Woodside Petroleum is pretty much symptomatic for how the sector has performed post-GFC overall. Not only has a dive in the price of oil from prices above US$100/bbl forced the industry to re-align operational costs and spending programs in line with the new pricing environment, capital allocation too has been disappointing across the board, across the industry, across the globe.
With all the easy oil reserves seemingly discovered and brought into production already, it seems the industry finds it a real challenge to achieve a satisfactory return on the funds spent annually to increase reserves, find new fields and bring them into production. I have argued for years that this new framework suggests a diversified portfolio should now carry less exposure, not more to the sector on a longer term view.
Investors with a longer term horizon might want to take all of this into account when momentum slows down and departs from the sector overall, as it eventually always does.
Most energy stocks in Australia are more LNG than crude oil, an observation that also features prominently in last week's re-initiation of coverage of the sector by CLSA. The analysts back my observation about there still being apparent value in the sector domestically, but not in every stock.
Taking a longer term view in combination with a positive outlook on LNG markets generally, CLSA has slapped Sell ratings on both Woodside Petroleum and Beach Energy, while rating both Oil Search ((OSH)) and Santos Outperform, albeit with the added observation the latter is now under corporate take-over attempt.
Target prices are $27.75, $1.12, $8.27 and $6.20 respectively.
CLSA's report warns the next wave of LNG investments and new projects is coming. Investors should brace for cost blow outs, project delays, and for shorter duration offtake contracts. Not that any of this matters in the short term...
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