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It has taken this long, but many oil market observers are now succumbing to the realisation that the present global oil market dynamics are likely to keep a ceiling on the oil price above US$55 per barrel (bbl) and a bottom below US$45/bbl.
As long as OPEC and Russia remain disciplined, and no major supply disruptions or geopolitical tensions occur, these are the levels at which swing producers in the Permian basin in the USA either thrive or perish, adding more supply or less into a well-supplied global market.
It is not unthinkable for the global oil market to go through the same scenario over and again: oil price rises, US frackers add more supply; oil price weakens, the highest cost and most price sensitive producers retreat; oil price rises, those swing producers join in again.
As long as these dynamics remain in place, and demand stays within reach of supply with and without US marginal producers, it seems the current range can remain in place for a long time.
The first seven months of 2017 have seen oil priced below expectations. Research updates on the energy sector in July have led to lowered forecasts, resulting in reduced valuations and price targets. Predictably, this has weighed on share prices.
Consider, for example, that FNArena’s consensus price target for Woodside (WPL:ASX) has fallen to near $30 from almost $33 in two months only. For Oil Search (OSH:ASX), the consensus target has fallen from $8 to $7.49. BHP (BHP:ASX) has felt the impact too, with its consensus target falling to $27.45.
An interesting new dynamic for sector investors in Australia stems from the divergence in USD priced oil and the surging AUD/USD on the misguided belief the RBA will soon embark on a tightening course. As such, the stronger Aussie dollar has now become yet another valuation headwind for a sector whose main product sells in USD. On Credit Suisse’s modelling, fair value for Woodside sunk to $17.50/share (not a typo), for Oil Search $4.15, for Santos (STO:ASX) $1.90 and for Origin Energy (ORG:ASX) $4.10.
Of course, these numbers are rubbery by nature, and nobody at this stage is expecting oil to remain steady at the current level, nor the Australian dollar to remain near 80 cents against the greenback. But, the broader issue here, argues Credit Suisse, is whether investors should now be paying closer attention to the currency and its possible impact on share price valuations. Credit Suisse thinks the answer is ‘yes’. Oil sector investors should be incorporating AUD/USD into their risk and valuation modelling, and accept it as another negative (‘valuation headwind’).
By far the largest threat to energy sector valuations is represented by long-term oil price projections used to make projections about cash flows, revenues and project returns. Short-term oil prices can swing heavily and they impact on share prices through short-term traders and algorithm robots, but large investors take their cue from longer-term projections and assumptions. If investors were to give up on the prospect of oil prices breaking out of the current range in the foreseeable future, this would have significant impact on valuations for energy producers today.
Worldwide, most sector analysts are working off a long-term oil price of US$65/bbl. In July, Citi decided to abandon that anchor and replace it with a long-term oil price forecast of US$55/bbl. Argue the analysts: signs of continuing productivity gains onshore USA have compressed the oil cost-curve.
Citi’s research concludes the incentive price to meet future demand has now permanently reduced to US$40-60/bbl. Putting the new long-term price forecast through Citi’s models causes valuations in Australia to deflate by between -8 to -23% while profit forecasts fall by between -12 to -50%.
One day before Citi released its valuations, JP Morgan/Ord Minnett had come to the same conclusion. Their new long-term oil price forecast is also US$55/bbl, down from US$60/bbl prior.
JP Morgan/Ord Minnett highlighted why these lower price projections are likely to have a major impact on the outlook, and thus valuation, of Woodside Petroleum:
“Sustained low oil prices have had the effect of not only lowering our estimated value for Woodside, but also potentially delaying or deferring the company’s growth projects.”
To date, most teams of energy sector analysts continue to work off US$65/bbl longer term. At a recent seminar, leading industry consultant Wood Mackenzie reiterated its view of a moderate price recovery for oil remains on the agenda by 2020, when US$65/bbl should be back.
Shorter term, the second half of 2017 could see a bounce in the oil price, while consensus is converging around global over-supply in 2018. The major risk for investors in the sector does not come from marginal surprises in timing and volumes, or from daily volatility which makes perfect timing difficult, but from the fact that more analysts might join the conclusion that US$55/bbl is now likely the new anchor, long term.
Bottom line: crude oil prices remaining range-bound for a prolonged time significantly increases the risk profile for investment opportunities in the sector, with capitulation by financial analysts on the long-term price average representing a tangible threat. Investors should adjust their strategy and exposure accordingly.
Content first published in the financial newsletter cuffelinks.com.au on 17 August 2017.