Hunt for value leads to oil upgrade By Harriet Mann | Wed, 8th...

Hunt for value leads to oil upgrade

By Harriet Mann | Wed, 8th July 2015 - 12:10


It's been a year since oil prices went into free-fall on fears of over-supply and a slump in demand, and the industry is gearing up for perhaps its most painful reporting season yet. Sentiment had improved in recent months, but the Greek crisis has sent prices skidding lower again and it may be too soon to bet on a recovery.
Cost cutting and hedging will have softened the blow for some of operators, but expect broken balance sheets to be laid bare in the upcoming reporting season. According to Deutsche Bank analyst Tom Robinson, net debt is set to soar by over a third to $8.9 billion, despite a 20% volume hedge, 13% production growth and 30% lower capex spend. Blame the industry's broken cash cycle, he says - over $2.3 billion of cash was spent in the first half of 2015.
"Absent a material improvement in the oil price, we struggle to see a turning point until mid-2016," says Robinson. "Valuation now reflects a $65 long term oil price and provides room for encouragement, but we argue weak fundamentals make it too early to position for a wholesale recovery."
On Wednesday, Brent crude fell another 1.2% to $56.18 a barrel and, despite a cheerier outlook recently, challenging fundamentals - funding, M&A and exploration - have put off investors.
Ahead of first-half results, Deutsche expects news of strong production growth and sales supported by the volume hedge. Sector cash profit is likely to have crashed by 42% to around $1.4 billion, but the broker believes perceptions around cost savings and further capex savings into 2016 - Deutsche expects a further 25% decline - have the potential to positively surprise.
That said, as hedging contracts come to an end in the second half of the year, realised pricing is likely to be dampened further. Robinson reckons leverage may rise to an "unsustainable" 3.3 times by the end of the year, with more geared names potentially reaching between 4-6 times.

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Finding value

Exploration budgets have crashed 65% and frontier drilling has all-but-vanished, so a recovery here is unlikely until 2017. But Robinson sees value. In fact, investors should view this sell-off as an opportunity to gain exploration exposure. Compared to some over-leveraged production/development peers, there is little debt and significant upside potential to be found.
"Viewing the sell-off as an opportunity to add well-funded E&Ps capable of exploring through the cycle, we upgrade Cairn Energy (CNE) to Buy," says Robinson.
As Cairn Energy returns to its second drilling phase in Senegal after last year's discovery, Robinson reckons it will be the standout explorer over the next six months. Its balance sheet is the "envy" of the town and the analyst expects cash preservation to have been strong in the period, ending at $750 million.

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The shares are worth 225p according to the analyst, which represents 35% upside to Wednesday's highs of 167p. He is confident the market is undervaluing the stock, which has a downside-upside net asset value (NAV) between 135-400p. Trading on 0.55 times price/NAV, the stock trades at a 5% discount to the sector.
There are other value plays to be consider, too. Premier Oil (PMO) (Buy, target price 215p) trades at a sizeable discount to core net asset value, and Genel Energy (GENL) (Buy, TP 700p) provides exposure to a world-class, low-cost resource.
But, investors should watch out for Ophir Energy (OPHR). Monetising its LNG assets could prove more difficult than expected and its exploration activity is all set for 2016. With an estimated NAV range of 75-215p, its risk/reward profile is less compelling than its peers. Like Cairn, the group trades at a 5% discount to the sector.
Robinson added:
Our long-term oil price of $80/bbl (2018+) is unchanged. Rolling forward our models to discount from 1.1.2016, we raise our NAVs by 6% (USD) and target prices by 4% (local). We see the sector trading on 0.5 8x P/NAV, a ~22% discount to 3-year historical levels (0.74x) and ~12% above mid-December trough levels (0.52x). Risks: Oil price, leverage, political risk, project execution.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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