Big oil's new basics

PORTFOLIO POINT: Global oil and gas reserves are on the rise, and listed energy resources stocks are feeling the pinch. Rather than growth stocks, they could become dividend plays.

It’s been a long time since anyone of significance used the words “peak oil”, and if recent events are a guide it may be many more years before it is heard again. For investors in oil and gas stocks, this is a development that changes the appeal of these stocks – in both a negative and positive sense.

Rather than arrive at a future suffering a shortage of liquid fuels, which is what we were told to expect for much of the past 20 years, we appear to be moving into an oil glut.

Deep-green environmentalists will find such a suggestion hard to stomach. Peak oil, like man-made climate change, has been their reason for existence.

Analysts who look a little closer can see a different future, and while there is no need to offload quality oil and gas stocks such as Woodside, Santos, Oil Search, Origin or Beach there are reasons to ask whether they have gone “ex-growth” and become yield plays.

The best oil and gas stocks could become very useful dividend generators, essentially becoming future high-yield stocks much like Telstra, a company with few growth options and stiff competition but with a mighty cash flow from legacy assets.

Woodside, for example, at its latest price of $34.27 is trading on a dividend yield of 3.3%, the same as is available on 30-day bank bills, and better than the 90-day bill rate of 3.19%.

Santos, at $11.03 is yielding 3.5%, higher than the 2.48% clients of JB Were are getting on cash deposited with the Goldman Sachs Cash Trust.

Traditionally, big resources companies are acquired for growth not yield, but with growth options declining, and institutional investors clamouring for higher returns to counteract ultra-low government bond yields, resource company management is being pressured to boost payouts and restrict new investments.

The decision of BHP Billiton to mothball its planned $50 billion Olympic Dam copper and uranium mine was partly a result of planning and production problems, but was also in response to investor demands for reduced risk and higher dividends, which translate into higher yields at current share prices.

In the case of Woodside, pressure is mounting on the company to not proceed with its $40 billion Browse LNG project, which is suffering similar planning problems as Olympic Dam. Woodside’s management could just as easily be under pressure to delay a development decision, re-directing cash into higher dividends.

Explorers and high-cost oil and gas producers are in a different category, because they will struggle to generate the profits factored into their spreadsheets at a time of higher forecast oil prices.

A glimpse of what might lie ahead for oil stocks was revealed in the quarterly reports of the global oil majors filed over the past two weeks.

All of the big names in world oil, including Shell, Chevron, Exxon Mobil and BP, reported profit declines ranging from 6% for Shell to 33% for Chevron.

Falling production by the majors, plus low oil prices late in the September quarter, did much of the damage. The Brent price, which is the marker crude oil used in Europe, peaked at US$117 a barrel in mid-August before tapering off to around US$107/bbl.

In the US, which uses the West Texas Intermediate blend of crude oils as a marker, the price peaked at US$100/bbl in early September before plunging to around US$85/bbl.

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There are multiple reasons for the difference between Brent and WTI, but the most important is that the growing global oil surplus is being felt most acutely in North America where a genuine glut of natural gas and associated liquids from gas wells is stealing market share from conventional oilfields.

The trick for investors is to look at the US gas glut and then consider four other factors, which are:

• What’s happening in US gas is “going global”.
• The US gas surplus has already decimated that country’s coal industry and severely damaged Australia’s coal-export industry.
• Nigeria’s high-powered finance minister has warned her government that they had best get used to a prolonged period of low oil prices, and
• All of this was predicted in mid-2010 by a US academic, who featured in the original shale-gas story Gas overload in Eureka Report.

Those four factors are linked with oil itself, the common denominator and a useful starting point to see that we are in the direction forecast by Amy Myers Jaffe from Rice University in the US oil capital, Houston.

It was Ms Jaffe who first sounded alarm bells over the potential (and now very real) effects of a dramatic rise in the production of gas from shale and other tight rocks that had been considered non-commercial for the previous 100 years.

“I am convinced that shale gas will revolutionise the (oil) industry, and change the world, in the coming decades. It will prevent the rise of any new cartels. It will alter geopolitics, and it will slow the transition to renewable energy,” she wrote.

Ms Jaffe’s revolution started with the collapse of gas prices in the US, an event which has had remarkable knock-on effects including the collapse of US coal prices as electricity generators switch to cheap and relatively low-polluting gas. It has also unleashed a flood of US coal into the global market which has, in turn, depressed the global coal price and severely damaged Australia’s coal industry.

If you follow the trail of creative destruction that has followed the rise of shale-gas production in the US you will find it leads to the balance sheet of big companies, including BHP Billiton, and the Australian government’s budget, which includes revenue from the Minerals Resources Rent Tax – revenue which is unlikely to arrive.

The impact on coal was one of the predictions made by Ms Jaffe. The speed at which it has happened is a surprise.

A closely-linked corollary effect of lower US gas prices and rising US coal exports is that the US has become a declining market for crude oil exported from the Middle East, South America and Africa.

Reduced US demand for imported oil is a dramatically significant force in the world oil market because oil exporting countries, which once assumed the US (the world’s biggest energy market) was a bottomless sink for their production now have to look for other growth markets.

China is an obvious growth market, but it too is on the shale gas trail and there is every reason to believe that the same geological forces which enriched the US with its prodigious reserves of oil and gas (conventional and unconventional) will be found in China, and in most other countries, including Australia.

Ms Jaffe’s revolution gained an acolyte last week when another highly-qualified player in the oil and gas industry warned about the danger to her country’s economy from lower oil prices.

Ngozi Okonjo-Iweala, Nigeria’s finance minister, said on the sidelines of a conference organised by the London stock exchange that lower oil prices were a threat because oil accounted for 80% of Nigeria’s budget.

Significantly, Ms Okonjo-Iweala is no slouch when it comes to economics or global politics. She is a Harvard-educated economist, a former managing director of the World Bank, and was runner-up in the election held earlier this year for the position of president of the World Bank.

On the outlook for oil prices she said in London that: “We are worried, we are concerned, because obviously many countries are discovering oil and gas, so the supply will be increasing over the next few years, and therefore we need to plan accordingly to make sure we have the necessary buffers in our own economy.”

Ms Okonjo-Iweala has been criticised in Nigeria for factoring in an oil price of US$75/bbl in her latest budget with critics demanding she use US$80/bbl to achieve a better look – not unlike Australia factoring MRRT revenue before it arrives.

Leaving the political implications to one side, the key to Ms Okonjo-Iweala’s remarks was the comment about “many countries discovering oil and gas”, an observation which might be a surprise to anyone not aware of what’s happening in the US.

Falling oil and gas prices are becoming a significant global force, just as Ms Jaffe predicted, with Australian coal not the only victim.

Across the US border, there is a crisis brewing in the Canadian oil sands industry that requires high oil prices to survive. Last week, the Wall Street Journal newspaper reported from Fort McMurray, the centre of Canadian oil sands, that they were: “suddenly, not a sure thing”.

Triggering that report was news from Suncor Energy, one of the biggest players in the oil sands industry, that it was reviewing a planned US$3 billion investment in upgrading its operations because of rising costs and “gyrating” oil prices.

While every oil sands operation has a different set of economics, the break-even price for some of the biggest is believed to be an oil price of more than US$100/bbl – US$15/bbl higher than the current WTI price against which the Canadian oil sands compete.

High-cost Australian oil and gas projects could also face the same force of higher competition as US gas makes its way into world markets, a once unthinkable possibility but one now in the planning stages with US LNG exports expected to start in the next few years, if permitted by the government.

Just as cheap US coal knocked high-cost Australian coal out of some markets, so too could cheap US liquefied natural gas (LNG) knock the economic fundamentals of Australian LNG projects.

If there is a central theme in what’s happening on multiple fronts, it is that the global energy market is undergoing a process of dramatic change, just as Ms Jaffe predicted.

The central issue is that oil and gas prices are falling, not rising, and while they might not fall in a straight line it would be an unwise investor who assumes that the forces unleashed by the shale gas revolution will suddenly reverse themselves.