OSH downgraded

Woodside, Oil Search downgraded
RBC Capital Markets has kicked Oil Search back to a sector perform rating, the same class as Santos, while Woodside Petroleum has been dumped to underperform.
Haydn Black
21 July 2017 09:24 News

Analyst Ben Wilson decided to downgrade the companies yesterday after looking at their latest quarterly results and RBC's own short and long-term oil price predictions.

"While we like Woodside's low-cost and reliable base operations, and the downgrade to our DCF [discounted cash flow] valuation is lower than other stocks in our universe, we think its defensive characteristics are now overvalued given its lack of medium-term growth options," he said.

While Wilson remains confident that Oil Search is well placed to sanction two additional trains in PNG he said the straight line nature of Oil Search's LNG contracts and its relatively high financial leverage makes it particularly sensitive to commodity price changes.

The main change in RBC's work hinges on material downgrades in its expectations for a recovery in the oil price, as OPEC's alliance with Russia isn't working and is fraying at the edges, while the US continues to push its own production ever higher.

Wilson said the chances of a recovery into 2018 were fading, and the market was anchored on near-term bearish market signals.

"These bearish market signals include stubbornly high OECD commercial crude and product inventories, the weekly escalating US horizontal rig count and signs of increasing tensions within the OPEC group leading to concerns over continued compliance with the November 2016 announced cuts."

It has knocked its expectation for Brent down by 11% to $51/bbl for 2017 and 16% for 2018 to $53/bbl, and into 2019 it can't see oil peaking above $57/bbl.

Its long-term forecast is down from $74/bbl to $64/bbl.

The driver in the the longer-term cut is a combination of general industry cost deflation and technological innovation leading to enhanced recoveries.

While Wilson notes RBC's price deck is below the broader analyst consensus, it says it sits above strip pricing, which highlights the condition where equity markets have been pricing in oil decks that are 10-20% higher than strip prices.

"We believe there are reasons for optimism, however the absolute extent of our optimism has reduced," he said.

While Wilson said Woodside was a low-cost producer, the numbers show it is long-dated with uncertain growth prospects and a high dividend/payout ratio.

"We liken it to a bond linked to oil/LNG pricing. On our revised oil deck we forecast dividend yields in the 3-5% range (before franking credits) over the 2017-19 period, which we think is insufficient risk/reward to encourage buying on a distribution basis alone."

While RBC has bumped up its shareprice target from $25 to $26, that is still lower than earlier in the year when it was tipping $30/share.

"Woodside has strong leverage to oil prices; however, we view it as being relatively more defensive and less leveraged than peers. As such, we think that strongly increasing oil prices, while positive for Woodside, will see it underperform peers," Wilson said.

"The opposite is also true, however, whereby we think Woodside will outperform peers in a declining oil market."

While RBC also likes Oil Search, it has downgraded the LNG producer's price target from $8 to $6.50 as its valuation no longer supports an outperform rating

"The high degree of oil price leverage among the Australian large cap E&P plays comes via the largely straight line LNG/oil linkages and their relatively high levels of gearing (with the exception of Woodside)," Wilson said.

There are a number of upcoming catalysts to a re-rating in Oil Search, including the upcoming Muruk and P'nyang appraisal drilling, which could add several trillion cubic feet of gas, and the expected sanction of the PNG LNG expansion next year, and if the oil price surprises to the upside RBC would have to revisit its rating.

There are also risks that the appraisal drilling doesn't pan out, political upheaval from the PNG election and ongoing landholder issues.