Are energy stocks good value or a dangerous value trap? That question is testing contrarians who see obvious value in beaten-up oil and gas stocks and are hunting for signs that the worst is over. The latest profit-reporting season gave hope, but it all depends on oil-price assumptions.
Morningstar, for example, has a US$100 a barrel forecast for Brent oil from 2018. Macquarie Equities Research assumes US$87.50 for Brent in 2017. The spot price is $US59.78. If these and other brokers are right, the energy sector looks reasonable value.
After savage price falls, 37 energy stocks that Morningstar analyses globally had a five-star rating in January 2015, meaning they were significantly undervalued. The median energy stock covered traded 27% below fair value and Morningstar said energy was “the cheapest sector”.
Macquarie said in February the four energy majors – Woodside Petroleum, Santos, Oil Search and Beach Energy – traded an at an average 16% discount to net asset value. It had an outperform call on Santos, Oil Search and Beach Energy, and was neutral on Woodside.
Consensus analyst forecasts show broking firms lifting valuations on the largest energy stocks. Woodside’s consensus price target of $38.68 compares with recent trades around $35. Santos’s $10.20 consensus target compares with a $7.89 share price. Oil Search’s $9.33 consensus price target compares with its $8.16 price, and Beach is trading below the $1.20 consensus target.
On that basis, the market believes the four energy majors are trading 10-20% below their fair value. Long-term investors, such as Self-Managed Superannuation Trustees, could capitalise on price weakness and buy, provided they have at least a 3 to 5-year view.
Those with a shorter investment horizon need to be cautious. The energy sector has a difficult few years ahead, as the oil supply adjusts to a lower price. Oil will eventually recover, as lower supply and firming demand drive prices higher. But forecasts of a sharply higher oil price (compared with the spot price) have a high degree of uncertainty.
A big unknown is how quickly developed nations move to a more energy-efficient future. This trend is become more pronounced in the energy sector as energy-saving appliances and energy-conscious consumers use less electricity and gas.
What will happen to the oil companies when electric and/or driverless cars become a bigger reality in the next five years? Ford Motor Co. CEO Mark Fields predicted in January that a major carmaker would produce a self-driving vehicle within five years.
Nobody knows how these trends will play out, or how they will affect energy producers. My point is that long-range forecasts for oil, based on traditional supply-and-demand metrics have a higher degree of forecasting error, in part because of the disruptive effect of technology on energy consumption – something few analysts seem to consider.
Long-term investors, who buy energy stocks on the basis of oil quickly recovering to trend prices, could be in for a shock: the odds favour lower energy prices for longer.
Woodside lacks appeal at current price
Forming a macro view on oil and listening to analyst views is important. But it’s always better to analyse companies from the ground up and analyse their guidance comments. The four energy majors mostly reported in line with market expectations – a solid rather than spectacular effort.
Woodside Petroleum reported record full-year net profit of US$2.4 billion for 2014, up 38% on the previous year, a touch higher than the consensus forecast of $2.38 billion.
It was a reasonable result: production rose 9% to 95 million barrels of oil equivalent, thanks to a full year of production at the Vincent FPSO asset, higher reliability at the Pluto and North West Shelf assets, and less impact from cyclones. A 13% increase in the average realised price for Woodside’s oil production underpinned higher earnings.
Woodside’s 2015 guidance was 84-91 million barrels and it said a US$1 decrease in the Brent oil price would reduce net profit by US$25 million. That’s okay, but Woodside’s big problems remains; short reserves life and a declining production profile in coming years.
It’s hard to get excited about Woodside at these levels, even though it has the balance-sheet strength to mop up weakened companies and reinvigorate its growth profile. Investors seeking large-cap oil exposure might find better value with European majors Royal Dutch Shell and BP Plc.
Chart 1: Woodside Petroleum
Source: ASX
Santos looks better
The energy giant posted net profit of $533 million for 2014, broadly in line with consensus forecasts. It was a reasonable result: production rose 6% to 54.1 million barrels of oil equivalent, a five-year high, and there were significant cost and efficiency gains.
Santos’s 2015 production guidance was unchanged at 57-64 million barrels of oil. The giant Gladstone Liquified Natural Gas project is more than 90% complete and the first gas is expected in the second half of 2015. The Papua New Guinea LNG project, delivered ahead of schedule last year and producing above expectations, will also drive higher output next year.
As production rises, capital expenditure and operating costs will fall. Santos forecasts its 2015 capital investment will be 44% below that of 2014. It is targeting a 10% drop in the cost of each barrel of oil, as it freezes staff numbers and pushes for bigger savings from suppliers.
There’s a lot to like about Santos at the current price. Gas is one of the fast-growing energy segments, Santos is well-positioned with a large base of proven resources and reserves, and a significant amount of capital expenditure is behind it.
Macquarie Equities Research has an outperform recommendation and a $12 price target for Santos, implying a total return in 12 months of around 50%. Morningstar has a buy recommendation and $18 fair value, although that depends on the US$100 oil price being achieved in the next few years. Using a US$60 oil price, Santos’s fair value is $10, says Morningstar.
At $7.89, the expected yield, fully franked, is almost 4% in FY15.
Chart 2: Santos
Source: ASX
Oil Search has long-term appeal
With Santos, Oil Search looks the pick of the energy stocks. Underlying net profit of $483 million for FY14 was 135% up on the previous year, just ahead of market expectation. A final ordinary dividend of US8 cents and US4 cent special dividend was a highlight. It was a good result.
The successful delivery of the flagship PNG LNG project last year helped lift production from 6.7 million barrels of oil equivalent to 19.3 million barrels. Oil Search is targeting production of 26-28 million barrels in 2015, with about two-thirds from its PNG LNG Project.
Like other energy producers, it is rapidly adapting to lower oil prices. It wants to cut around 20% from production costs and planned capital expenditure in 2015. Higher production, lower operating costs, and potential to expand the PNG LNG project and Elk/Antelope fields bode well for Oil Search in 2015.
After falling from 52-week high of $9.88 to $8.16, Oil Search looks undervalued. Four of seven brokers in consensus analysis have a strong buy recommendation. Three have a hold.
However, caution is needed: Oil Search has higher risk than other energy majors, principally because its key assets are in PNG. Country risk and commodity-price risk, if the oil slide continues are significant potential sources of volatility. But Oil Search has shown it can manage both risks well and has strong leverage to the oil price’s gradual recovery.
Chart 3: Oil Search
Source: ASX
Beach Energy in value territory
The Adelaide-based producer has slumped from a 52-week high of $1.82 to $1.09, hampered by the falling oil price and negative sentiment towards energy stocks. Its principal producing assets are in the Cooper and Eromanga Basins in SA and in Egypt.
Beach reported underlying net profit of $72.4 million for the first half of FY15, down from $158.1 million a year earlier and below analyst forecasts. Lower realised oil prices and lower third-party sales volumes weighed on the result.
Production of 4.8 million barrels of oil equivalent was a touch down on the record production in the previous half. Beach’s FY15 production guidance is 8.9-9.4 million barrels.
Beach revised capital-expenditure guidance from $450-$500 million in FY15 to $430-$470 million and continues to find good cost efficiencies in the business.
Like Oil Search, Beach is trading below the consensus analyst estimate of fair value, but comes with higher risk. Over the years, it has created significant value in trading assets – a strategy that may prove harder in a low oil-price environment. Assets in shale oil and in northern Africa, and Beach’s reliance on exploration success add to the risk profile.
Still, Beach has a healthy balance sheet, good cash flow, long-life resources and reserves and is well run. It also has strong potential from unconventional energy assets.
At $1.09 a share, Beach has attractions, although on a risk-adjusted basis it does not look as compelling for long-term portfolio investors as Santos.
Chart 4: Beach Energy
Source: ASX
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at February 28, 2015
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
