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Oil prices fell 30% in a single session this week, the biggest losses I have seen as a professional investor and the worst single decline since the first Gulf War in 1991. So, what happened?
The first answer is the same one offered to most problems lately; coronavirus. China has shutdown most of its industrial production over the past few weeks and is only now just awakening.
All over the world, production, transport and energy generation have fallen dramatically in the wake of the pandemic. Oil demand has been weak, along with LNG, coal and gas demand.
Into this environment land Saudi Arabia and Russia, two of the largest producers in the world, who were widely tipped to negotiate a deal that would cut supply to distressed markets. That didn't happen.
Instead, Saudi Arabia sensationally discounted its own oil output and unilaterally committed to lifting output to its full capacity.
Saudi Arabia plays a special role in the oil markets. A combination of unmatched production capacity and state ownership means it can afford to hold back on output.
Although the US and Russia have largely caught up to Saudi Arabia in terms of output - they all produce roughly 10m barrels of oil per day (bpd) - Saudi alone is holding back on production.
This has historically been used as a threat to enforce quotas within OPEC, the oil production cartel. With the world's lowest production costs, the Saudis have long threatened to increase output to lower prices and hurt peers. It has now made good on that threat.
Not only has Saudi Arabia committed to adding over 1mbpd of additional capacity into an already oversupplied oil market, they have also unilaterally cut prices. The market has gone from expecting an oversupply to correct to expecting it to worsen. No wonder oil prices tanked.
This has devastated oil producers and suppliers all over the world.
On the ASX, Woodside fell 18% in the session, Santos fell 27% and Oil Search plummeted 35% in a single day. BHP, which boasts the largest oil business on the market, fell over 14%, while Worley, the largest contractor on the stock exchange, fell almost 20%, as did most other service providers. Smaller oil producers were significantly lower too.
What happens from here? Market falls are a response to lower oil prices and, for the moment, lower oil prices will prevail.
We currently have a Buy on Woodside and the investment case can be reviewed here. We have assumed oil price around the US$50 mark in assessing Woodside's value. Both WTI and Brent, the two main oil benchmarks, currently hover around US$30.
Woodside's revenue isn't as simple as a linear trace of the oil price. As an LNG producer, its contracts track the oil price with lags and floors. Over the short term profits will fall, but not as sharply as the oil price has. When the time comes for contracts to be renegotiated, however, Woodside's value will fall if oil prices persist at this level.
A collapse in demand has never been met with a wall of new supply as it is now. Markets aren't irrational in marking down oil prices and, if producers do not act, prices are likely to stay where they are for months.
If rationality prevails, Saudi Arabia and Russia will reach a new agreement and withdraw supply to support prices.
Even if that doesn't happen, US shale producers, the other large swing producers in the industry, will quickly go bust. As we have noted for years, US shale exists with the aid of cheap debt and dubious accounting.
We don't believe any shale producer generates sustainable free cash flow and, at these prices, production will fall swiftly as producers with bloated balance sheets go bust.
This presents an interesting scenario. In our view, either the giants get together and restore order to the market or shale producers take the fall. Either way, we can't see how oil prices can be sustainable at US$30, especially as industries recover from the pandemic.
If you don't have any exposure to the sector, this is the time to seek it. With a rock-solid balance sheet, low-cost production and ample growth opportunities, Woodside remains the best exposure in the industry.
If oil prices remain low for an extended time, it is likely that Woodside's growth projects will be delayed. Keeping portfolio limits in check remains vital given that the value of this business is intricately linked to energy prices. With that caveat, Woodside remains a BUY.
We are also tantalised by BHP which is now a mere 10% above our upgrade price. BHP is the world's best resources business and it is now on our radar again courtesy of the mayhem in oil. We would upgrade at prices below $25.
Worley looks superficially cheap but carries too much debt. Santos similarly looks cheap on numbers, but we've long been hesitant to upgrade it due to its lower asset quality and significantly indebted balance sheet. Origin Energy, with a huge retail energy business in all sorts of trouble, is not a sensible way to play oil and is a special situation for another day.
Oil Search is another intriguing prospect. It fell an astonishing 35% in a single session despite having a stake in arguably the best LNG project of any of its peers. The business is struggling in Papua New Guinea (PNG) where the government appears to be blocking expansion plans. We now value growth of the project at zero.
That still leaves two existing LNG trains, which should generate about US$900m in free cash flows per year at US$60 a barrel. At that price, Oil Search's stake is likely worth around $5-6 a share. Yet it languishes at just over $3 a share.
Some of that discount reflects where oil prices sit now but it also reflects fear about additional changes in PNG. Oil Search appears cheap but, like most cheap assets, attracts higher risk. The company was due to sell project equity in its Alaskan fields but any deal will likely be delayed now. In the meantime, its balance sheet and cash flows will deteriorate with the oil price. The market is probably concerned about the need to raise capital which, at these prices, would be devastating. An opportunity is brewing but risks are high so we're removing price guides while keeping an eye on its capital position. HOLD.
We don't often upgrade or hold energy businesses. They are cyclical, capital intensive and attract larger than average risk. For those so inclined, however, this is the time to be looking at them. We still recommend patience; a price war has begun and it may not settle quickly. But a long term outlook remains our key advantage in this sector.
Gaurav Sodhi is the Deputy Head of Research at Intelligent Investor. To access more share research, start a 15 day free trial.