Oil & Gas: Trade War 2.0?

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
14 May 2020, 8:50 AM
Sectors Covered:
Mining, Energy

  • The recent recovery in oil & gas stocks has been positive, but some have materially outpaced oil prices, and in doing so have essentially priced in a rapid v-shaped recovery that is looking increasingly unlikely.
  • We see the oil market moving into its third phase of downturn, which we identify as emerging supply curtailments (in addition to OPEC+ cuts) but also weak demand.
  • A meaningful recovery in oil demand is not solely reliant on lockdowns being removed, with long-term economic fallout from Covid-19 appearing likely.
  • We see:
    • a) a 10% chance the current rally is sustained by a v-shaped recovery emerging,
    • b) a 50% probability of a multi-year gradual recovery in demand, and
    • c) a 40% probability of a below consensus decline in demand/growth.
  • We have downgraded our oil price assumptions to better reflect a multi-year gradual recovery (i.e. oil consumption does not reach 2019 levels until 2022).
  • Post their recent rallies, outperforming Woodside Petroleum (WPL), Santos (STO) and Oil Search (OSH) now appear fair value on a 12-month investment horizon given current conditions/risks.

Large caps appear fair value for now

We remain long-term oil bulls, but it is hard to maintain this positivity towards the sector when key energy stocks (WPL, STO and OSH) so strongly outperform oil prices, as has been the case during April/May.

This has resulted in WPL trading in line with an implied oil price of ~US$47/bbl, STO ~US$42/bbl, and OSH ~US$47/bbl, supporting the view the market is looking ahead to a c.2022 recovery.

We view this level of market optimism as dangerous given not only the massive demand impact from Covid-19 restrictions, but also because of new macro risks emerging. Key amongst these is the growing risk of a new Trade War breaking out between the US and China, with tensions escalating from the ongoing health and economic crisis.

Even barring a new trade war, we expect oil demand loss (currently at an unprecedented c.30mb/d) will take multiple years to recover, with the market not yet in a position to accurately analyse all of the fallout.

Demand recovery will take time

The economic fallout from global Covid-19 restrictions, which has brought most economies to near standstill, will likely have long-term implications. We see a high probability of this having an extended impact on demand for oil, and now forecast that global oil demand does not recover to 2019 levels until circa 2022.It is not all doom and gloom, we still expect a supply response (both strategic and forced) as likely to continue building which will gradually (inevitably) support higher oil prices in time.

Oil price forecast changes

While we see oil prices at/near a cycle low, we also see fundamental demand-supply conditions that could see the recovery phase become protracted and take considerable time to rise back above US$60/bbl.

Accordingly we have downgraded our Brent oil forecasts over the medium- and long-term (summarised in Figure 1).

In terms of resulting price target changes: our WPL price target falls to A$22.56 (was A$26.61), STO PT to A$4.39 (was A$4.72), OSH PT to A$2.82 (was A$3.55), SXY PT to A$0.41 (was A$0.49), and KAR PT to A$1.13 (was A$1.57). COE’s PT is unchanged at A$0.56 given its limited oil exposure.

These changes to our oil deck represent a significant shift in our assumptions onto more conservative footing, sitting below current global consensus oil forecasts.

We view this as reasonable given the weight of near-term fundamentals.

A good time to take stock

Trading with implied oil prices in the mid-$40s, versus a spot oil price of ~US$29/bbl, supports our view that the April/May share price rally has pushed WPL, STO and OSH into fair value territory on a 12-month investment time horizon. While we see appealing long- term value potential beyond this timeframe, making these stocks worth holding onto, we do view prices as only representing fair value given current conditions/risks.

Rating changes

With growth aspirations on hold across the sector, and post the changes to our oil price forecasts, we downgrade WPL to Hold (from Add), STO to Hold (from Add), and OSH to Hold (from Add). With small caps having materially underperformed we still see upside potential for SXY (Add maintained), COE (Add maintained) and KAR (Add maintained).

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