Equity Strategy
20 September 2023
Oil and Gas - Crude Awakening
OPEC Cuts Push the Oil Price above $90 Per Barrel

Favourable supply/demand dynamics in the global energy market have pushed the oil price >30% higher since late June to ~US$94 per barrel, representing a ~10-month high for the commodity.

The resilience of major economies and the lifting of pandemic lockdowns in China have contributed to strong global energy demand this year, despite headwinds from elevated inflation and interest rate hikes. 

Meanwhile, the supply side of the equation is also tight. OPEC has continued to cut production, with major oil exporters Saudi Arabia and Russia recently extending voluntary supply cuts of a combined 1.3 million barrels per day to the end of 2023. 

The combination of resilient energy demand and a tight supply backdrop will lock in a market deficit through 4Q23, providing a tailwind to the global oil price in recent months, acting as a boon for companies operating in the energy sector, including our position in Woodside Energy (WDS) (Focus Portfolio 4%) and Worley (WOR) (2%). 

Figure 1: The oil price has rallied since July through a combination of stronger-than-expected demand and OPEC cuts

Supply Remains Tight

Proactive OPEC keeping market tight over the short term

OPEC's commitment to production adjustments in response to evolving market dynamics suggests a readiness to stabilise and elevate oil prices in the face of softening demand.

Saudi Arabia, the United Arab Emirates (UAE), and others may think production cuts are working with the oil price above $90 per barrel. However, if China's growth continues to slow, limited oil demand drivers remain after a rebound post-COVID. Major producers might extend cuts if they see China's demand risks growing, keeping oil supply tight. 

Figure 2: Oil market expected to remain tight over the short term; OPEC holds the power
Figure 3: Global oil and gas CAPEX is recovering, but remains well below 2014 levels

Underinvestment sets the energy market up for further supply shocks

Underinvestment in the energy sector will keep global supply tight over the medium term. Energy markets were already tight before Russia/Ukraine, with limited capital expenditure in oil and gas since 2014. The Russia/Ukraine conflict highlighted the fragility of the market and concentration of risk in terms of production.

In upstream oil and gas, the industry at the peak was spending US$800 billion per annum, which troughed at $350 billion in 2020, but has only since recovered to $400 billion in 2022, even with a bounce in demand and price.

Oil and gas investment should increase. However,  new supply will take time to come online, leaving a market that will likely be tight over the medium term.

A tight market is a tailwind for the energy outlook over the next few years. The market is now significantly more susceptible to supply and demand shocks like the Russia/Ukraine conflict, OPEC surprises and potential China stimulus. 

Demand to Grow this Decade

Oil demand will persist over the medium term. The International Energy Agency (IEA) expects oil demand to reach 105.7mb/d by 2028 (from 99.8mb/d in 2022), with the majority of this demand coming from Asia.

While the energy transition will reduce demand for oil from developed countries, the developing world will continue to drive demand growth. 

Asia Pacific is expected to account for 90% of global growth. Using Wilsons estimates, China is expected to double its oil consumption by 2036 and India is expecting to grow consumption by 82% during this same period. Under this scenario, China and India collectively are expected to increase oil consumption by 1.30 mmbls/d every year on average for the next decade, leading consumption growth globally.

Oil demand is not going away and will remain a key commodity over the next decade – and possibly beyond. 

Figure 4: Asia will drive demand for oil over the medium term

Global Gas Market Could Be Tighter than Oil

On a long-term basis, we expect the Russia-Ukraine war to have a greater impact on the global gas market than on the oil market. This will likely lead to tighter liquefied natural gas (LNG) markets and higher LNG prices. 

Russia should be able to redirect most of its oil exports over time since oil is fungible. However, Russia cannot reroute its piped gas exports away from Europe without considerable capital spend. 

With the European Union (EU) indicating that it plans to diversify its energy sources away from Russian gas over the next few years, we believe LNG from Qatar, the US and Asia will provide the bulk of alternative gas imports to the EU. Australian LNG will likely fill the subsequent gap in Asia. This is a bullish outlook for Australian LNG stocks like WDS.

Figure 5: LNG prices are expected to remain elevated into 2024

Stronger for Longer

Strong tailwinds are anticipated in the energy sector, with fundamentals pointing towards demand growth and supply constraints in the medium term. 

With this market tightness to persist over the medium term, we expect the long-term price for oil (currently at ~$75) to rise as the market stays stronger for longer. A higher long-term price would be value accretive for oil and gas stocks. 

Hence, our overweight is not contingent on continuous oil price increases. Rather, the attractiveness of WDS/WOR hinges on the oil price remaining elevated compared to the projected long-term price.

Figure 6: Long term oil prices look conservative given the tight backdrop

What Does This Mean for Our Energy Positioning?

Remain overweight Oil and Gas

The Focus Portfolio’s energy exposure is via Woodside (WDS) and Worley (WOR). While these stocks have outperformed of late, we continue to remain overweight the sector. The Focus Portfolio has a 6% weighting to oil and gas stocks vs the ASX 300 at 5%.

The tightness of the energy market over the medium term keeps us of the view that there is upside risk to the long-term consensus oil price. This would have a significant impact on the valuation of WDS.

The valuation of WDS increases ~$5 for every $10/bbl rise in the oil price. In the near term, if oil prices maintain $90 per barrel in 2024, it could potentially result in a FY24 (Dec ye) free cash flow yield of ~8%, as opposed to the current consensus of 6.5%.

In a constrained market, it's probable that oil and gas prices will experience significant volatility owing to ongoing disruptions in supply and demand. This situation is advantageous for oil and gas energy companies like Woodside and its shareholders. Price upswings enhance producers' cash flow, resulting in higher dividends for shareholders.

Worley (WOR) is well placed to benefit from an oil and gas CAPEX investment cycle as this will likely translate to contract wins for the business, driving growth in its work backlog and therefore its expected future earnings.

Figure 7: WOR should benefit from a higher oil price as the market expects more O&G capex

WDS > STO – Cash Flow is King

We hold a preference for Woodside (WDS) over Santos (STO) due to:

  • Free cash flow superiority
    • There is a plausible scenario that STO will have a negative free cash flow yield in FY24.
    • By FY25 WDS is expected to have a free cash flow (FCF) yield of 8.3% vs STO of 4.2%
  • Capital management
    • We prefer WDS’s approach to capital management with a higher return to shareholders
    • Oil price shocks should benefit WDS shareholders more as more capital can be returned via dividends
  • Risks - STO has higher project associated risks than WDS
  • Management team - The merger of BHP-P and WDS in 2022 highlighted the quality of WDS's management. This was an astute deal.
Figure 8: WDS’s FCF yield is higher than STO’s over the next 3 years
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Written by

Rob Crookston, Equity Strategist

Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.

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