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In this Coronavirus Crash, we’ve been bombarded by numbers we never thought we would see: but one of the most alarming was the “negative oil price” of April.
Lower oil prices have always been seen as a huge stimulant to the global economy – and would have been welcomed, normally, in a situation such as the worldwide economic downturn we face – but negative? That is beyond scary.
Many investors were prepared for lower oil prices – there was already chronic over-supply in the market before the Saudi Arabia-Russia pact to restrain production broke apart so spectacularly in March – but negative prices were definitely not expected.
But investors need to look beyond the headlines to get a gauge on oil as an investment.
Yes, there has been – and continue to be – very severe dislocations in the oil markets, but the negative oil prices were essentially a “bug” in the oil futures market: futures for West Texas Intermediate (WTI) crude oil, the dominant North American oil grade, have to be settled through physical delivery, and that was what tipped low prices into actual panic in April. Speculators holding the contracts for the delivered oil had nowhere to put it, and as the deadline for futures contract expiry of April 21 loomed, they had to pay other market players to take those contracts off their hands.
(One thing that may come out of this debacle is that there could be – should be – greater focus in the futures markets on the contracts for Brent crude oil, the major European (North Sea) grade: Brent futures contracts can be settled for cash.)
Investors accept that the severe economic downturn on the back of the pandemic has hammered oil demand, and thus prices – but the oil futures market turmoil was unexpected ugly. And so is the geo-political background: the Saudis and Russians have effectively been trying to kill the US shale oil industry, which has undercut them and helped to turn the US into a net exporter of energy. They may have gone a long way toward their aim, because the outlook for much of the US shale sector is very bad. Many companies will not survive prices this low.
But in commodities markets, one thing we know is that ultimately, “the cure for low commodity prices is low commodity prices.” Marginal production gets culled by low prices, and production falls. (The mirror saying is “the cure for high commodity prices is high commodity prices”: when prices are high, new production comes into the market, and the prices eventually fall.)
The big oil producers are turning off the taps. OPEC+, which is the Organisation of Petroleum-Exporting Companies (OPEC) plus a group of non-OPEC members including Russia and Mexico, are cutting production across May and June, and Norway, another major non-OPEC country, is also winding back production.
Oil prices at prevailing low levels are not sustainable – economies kick-starting themselves back to life will need oil, and gas. Particularly China.
Most estimates of oil price recovery see the commodity around US$40 a barrel to US$50 a barrel at some point in FY21 – but with the potential to dip back below US$20 a barrel, as global economies tentatively make their way out of downturn.
When you talk about Australian hydrocarbon companies, you’re really talking about gas. Liquefied natural gas (LNG) prices are based on oil prices, so they followed it down. There is a rising glut of gas depressing prices, but Australian LNG companies sell most of the commodity through long-term contracts.
Let’s look at Australian producers – we’ll rank the “big five” (excluding BHP) for their investment attractiveness at the moment.
2020 peak: $8.86
Analysts’ consensus price target: $6.42 (FN Arena), $6.90 (Thomson Reuters)
Integrated gas producer and energy retailer saw gas revenue slip by 12% in the March quarter, and electricity volumes dip as economic downturn hit. The company has put its major expansion project, the Beetaloo gas project in the Northern Territory, on hold.
But on the positive front Origin renegotiated a critical LNG supply deal with Sinopec, a 25% partner in the Origin-operated APLNG gas project in Queensland. Sinopec cut the volume it will buy this year by 10%, but the Sinopec negotiation was the first price review under APLNG’s long-term contract with Sinopec, and the fact that there was no change to the contract price was seen as a big relief for the LNG market, with spot prices at record lows amid plunging demand. APLNG is seen as tracking quite well, with ORG’s share of production running ahead of forecasts.
Analysts were fairly happy with the outcome, and some lifted earnings estimates – although electricity sales volumes have been hit more by the coronavirus pandemic than the analyst community had expected, and there is caution around how this could play out. Origin says the demand impact from the Covid-19 pandemic remains “in line” with its earnings guidance assumptions for FY20.
That leaves analysts quite bullish on Origin at current prices: and the stock appears to offer a 4.5% fully franked yield for FY20, or 6.4% grossed-up. ORG certainly appears a sound total-return opportunity, absent any unexpected deterioration in the outlook.
2020 peak: $2.87
Analysts’ consensus price target: $1.74 (FN Arena), $1.73 (Thomson Reuters)
After the transformational purchase in 2018 of Lattice Energy, Origin Energy’s upstream oil and gas business, Beach is now Australia’s largest onshore oil producer, with a core focus on exploring and developing its 69,000sq km-plus acreage in the Cooper Basin. It also has operating interests in offshore projects in Victoria, Tasmania and New Zealand. Beach has also cut its capital spending by up to 30%, but is also in a strong balance-sheet situation: it is in a net cash position, with $80 million in cash and about $530 million in extra liquidity available to ride out the downturn. In fact, the company has reassured investors that revenues from its gas business – 75% of which are under fixed contracts not linked to the oil price – cover all of its operating and “stay-in-business” costs, even if the oil price is less than zero.
Beach says its updated FY20 financial guidance – which it lowered in March – still stands, although operations are tracking along at the lower end of its guidance: the company gave underlying EBITDA (earnings before interest, tax, depreciation and amortisation) guidance $1.175 billion–$1.25 billion. An expected dividend of 2.1 cents implies an expected fully franked yield of 1.5%, or 2.1% grossed-up.
2020 peak: $9.00
Analysts’ consensus price target: $5.45 (FN Arena), $5.40 (Thomson Reuters)
Santos has producing assets in SA’s Cooper Basin, as well as with partners in WA’s Carnarvon Basin, the Darwin LNG project in the NT, and the Gladstone CSG-LNG project in Queensland. It is also a foundation partner in the PNG LNG project in Papua New Guinea. Like Woodside, Santos is also viewed by brokers as having has the balance sheet to withstand a number of years of very low oil prices, while also having growth opportunities in its assets. Weak oil prices are putting pressure on the company’s earnings, but it doesn’t have any debt repayment due until 2022 – strong gas production in the Cooper basin and fixed price contracts are definitely helping Santos.
In March, Santos cut its full-year capital spending by 40% – by about $US550 million ($850 million) and deferred an investment decision on its US$4.7 billion ($7.2 billion) Barossa gas project off northern Australia, in which it recently sold a stake to Japan’s JERA. STO also announced a target breakeven oil price of US$25 per barrel: the company says that about 70% of its forecast production volumes were either fixed-price domestic gas contracts, or oil hedged at an average floor price of US$39 a barrel.
Analysts are fairly comfortable with Santos’ ability to rebound. Like Woodside, the 2020 dividend (calendar-year) will be down on the 11 US cents from last year, but the consensus forecast of 8.2 US cents equates to 2.9% fully franked at current exchange rates, or 4.1% grossed-up.
2020 peak: $35.36
Analysts’ consensus price target: $24.41 (FN Arena), $23.67 (Thomson Reuters)
Australia’s oil and gas heavyweight has reacted to the downturn by delaying pushing the “go” button its major LNG expansion projects, Browse and Scarborough, and halving its capital spending in 2020, to protect the company against plunging oil prices and the economic impact of the pandemic. A final investment decision on Scarborough, initially due in June, will now be made in 2021 – a revised date for Browse has not been set.
Woodside reported first-quarter sales revenue down more than 20%: it said average sales prices for its products during the quarter amounted to US$45 per barrels of oil equivalent (BOE), more than US$10 lower than a year earlier.
But Woodside is an experienced and well-managed company: it has hedged 13.35 million barrels of oil production over the April-December period at an average of US$33.03 a barrel. The company has a balance sheet strong enough to ride out the storm: broker Credit Suisse argues that Woodside can withstand oil prices as low as US$10 a barrel for FY20 and US$15 a barrel throughout 2021, without risking debt covenants. As UBS points out, Woodside’s breakeven production cost of US$20 a barrel should produce a profit in 2020 (WPL reports on a calendar-year basis) and pay a dividend. That dividend will likely be a long way short of 2019’s 91 US cents – on FN Arena’s analysts’ estimates collation, analysts expect 18.5 US cents this year, rising to 40 US cents in 2021.
At current exchange rates, that puts WPL on an FY21 fully franked yield of 3.1%, grossed-up to 4.4%.
2020 peak: $7.74
Analysts’ consensus price target: $3.07 (FN Arena), $3.33 (Thomson Reuters)
The Papua New Guinea-based Oil Search – which is still working on a $20 billion LNG expansion in PNG –conceded in April that it would consider selling part of its stake in the PNG LNG project to further boost its balance sheet, if a US$700 million ($1.2 billion) equity raising fails to overcome a prolonged oil price rout. Of its ASX-listed peers, Oil Search needs a comparatively higher oil price: broker Macquarie estimates that OSH needs oil to be at US$33 a barrel over 2020 (which is unlikely) to break-even at the free-cash-flow level. Before the equity raising, Oil Search had US$3.65 billion ($5.6 billion) in debt, and the finance costs push that break-even figure higher.
Macquarie estimates that if oil stays below US$20 a barrel for the remainder of 2020 and trades below US$30 a barrel from June 2020 to June 2021, that could push Oil Search into breach of its debt covenants with its lenders – never a good situation. There is also constant political risk with OSH, as it regularly has to negotiate royalty-sharing agreements with the PNG government.
The share market has also been unimpressed with the company’s major diversification into Alaska, where it
spent $850 million buying a 51% stake in the Pikka prospect. Oil Search plans to start producing in Alaska as early as 2022 to help meet a target of doubling its annual output to around 60 million barrels of oil equivalent by 2025.
Oil Search shareholders are also staring at a slashed dividend: FN Arena has analysts expecting 1.3 US cents in FY20, down from 9.5 US cents last year.
Plus, here are two junior producers that look quite attractive at current levels:
2020 peak: 63 cents
Analysts’ consensus price target: 53.8 cents (FN Arena), 56 cents (Thomson Reuters)
Originally focused on Central Australia’s Cooper Basin, Adelaide-based Cooper Energy has expanded its portfolio of assets into the Otway and Gippsland basins of Victoria. COE is not far off the full commissioning of APA’s Orbost gas processing plant, which will allow gas from its Sole project into the east coast of Australia with several large long-term fixed-price contracts already in place.
Apart from Sole, Cooper has in the pipeline the re-commissioning of the idle Minerva Gas Processing Project in the Otway Basin in western Victoria coming along – which it half-owns with Japanese group Mitsui – which will be a low-cost processing hub for gas from the joint venture’s offshore Casino Henry gas field, and other discoveries. There is also the Otway Phase-3 Development Project (OP3D), which potentially could bring a further 100 PJ-plus of gas to the market from 2022 onwards.
2020 peak: 37 cents
Analysts’ consensus price target: n/a
Onshore oil and gas explorer and producer Senex Energy has oil and gas assets in SA’s Cooper Basin as well as gas assets in Queensland’s Surat Basin. Senex had a strong quarter in March 2020, with total quarterly production up 31 per cent to 589,000 barrels of oil equivalent (BOE), with gas and gas liquids volumes from the Surat Basin and the Gemba field of the Cooper Basin increasing by 68%. That flowed into sales revenue of more than $33 million for the quarter, up 13%
Senex is relatively protected by its fixed-price contracts. At its Project Atlas, which supplies domestic customers, more than 60% of expected gas production is contracted at robust fixed prices through to the end of 2022. At Roma North, the oil-linked gas sales agreement with the GLNG export project is protected such that it delivers positive operating cashflow at below US$15 a barrel, and gas revenue of more than A$5 per gigajoule, at an oil price of US$27 a barrel and an A$/US$ exchange rate of 60 cents. Senex has reiterated its production guidance of between 1.8 million–2 million BOE for FY20, compared to 1.2 million BOE in FY19.