Oil's bumpy road back

The recovery might be underway, but that doesn't mean you should rush in yet.

Summary: Analysts believe that the worst is over for oil producers, but expect volatility to continue for some time as the oil price continues to bounce around. 

Key take out: Cost cutting at our major producers will have a positive impact, but there's no need to rush in yet. 

Key beneficiaries: Home owners. Category: Commodities. 

Two years after oil started its spectacular 70 per cent price plunge, it’s safe to say that the worst is over for petroleum producers, though it would be wise to expect more of the volatility seen over the past few weeks before a sustainable recovery takes hold.

Australia’s big four oil and gas stocks, Woodside, Oil Search, Santos and Origin Energy, have all moved up from from their share-price lows posted earlier this year when oil briefly dipped below $US30 a barrel.

Woodside is up from $23.82 to $26.80. Santos has almost doubled from $2.46 to $4.70. Oil Search is up from $5.56 to $6.80, and Origin has risen from $3.44 to $5.66.

Woodside Petroleum share price, past 10 days:

Encouraging as the upward trend looks, all oil-exposed stocks are being buffeted by sharp moves in the underlying price of oil which is the critical factor in determining the price of liquefied natural gas (LNG), the product which dominates the four oil and gas leaders.

Last week, for example, the oil price dropped by an alarming 10 per cent from near $US50/bbl to $US45/bbl, followed by last night’s 5.5 per cent bounce back to $US48.50/bbl for Brent-quality crude.

Those are big moves in one of the world’s most actively-traded commodities and a guide to the games being played by oil producing countries and oil traders which can have a sharp short-term effect on the share prices of oil-producing companies.

Despite the short-term shocks there is a steady improvement evident in oil supply and demand as the market moves back into balance after a surge in output in 2014 when Saudi Arabia refused to play the role of swing producer, opting instead for a policy aimed at crushing higher-cost competitors, especially the newcomer to oil, US “shale” producers.

It was Saudi Arabia’s decision to leave open the spigots on its oilfields which caused the oil price to drop from more than $US100/bbl at this time in 2014 to less than $US30/bbl in January.

Repeat doses of the daily 5-to-10 per cent price swings are likely over the next six months creating a stop-start market, which is why investors have no need to rush back into the sector.

A close look at how the leading oil and gas stocks are performing in uncertain times will come next week with a daily diet of quarterly production reports.

Oil Search is scheduled to be the first cab off the rank filing its June quarter report at the ASX on Tuesday (July 19) with little change expected from its March quarter output of 7.7 million barrels of oil equivalent (a combination of oil and gas).

Neither is it expected that there will be any development in the big issue at Oil Search, its attempt to acquire fellow Papua New Guinea petroleum company, InterOil.

Woodside follows the quarterly reporting procession on Thursday, though there is an “oil-related” event scheduled for Wednesday when BHP Billiton files its full year operational review with its oil division re-emerging as a leading profit centre.

Santos rounds out a busy week for Australia’s oil industry with its June quarter report scheduled for release on Friday and Origin follows the week after with its quarterly, scheduled for June 29.

Most of the data being released will be about volumes produced not financial performance though a rough guide to profits (and losses) can be gleaned from oil and gas production numbers.

Before last week’s price correction (and last night’s recovery) the mood among oil analysts had moved up from a negative view to widespread hold recommendations. Intelligent Investor’s Gaurav Sodhi has a neutral ranking on Australia’s top four oil and gas stocks.

UBS upgraded its view of Woodside on July 7 from neutral to buy with a 12-month share price target of $29.50, retained a neutral recommendation on Santos and upgraded a second-tier producer, Beach Energy, from sell to neutral.

Morgan Stanley has a slightly different pecking order but has also made a number of recent changes. Woodside has been upgraded from hold to buy, Santos and Origin have gone up from underweight (sell) to equal-weight (hold).

Macquarie is the optimist with a rating buy for Santos and four smaller oil and gas stocks; AWE, Karoon, Senex and Sino Gas, followed by neutral ratings for Woodside and Beach. Macquarie is restricted on what it can advise on Oil Search and InterOil.

The snapshot of what the analysts think reinforces the point about the oil and gas sector having entered a period of change with the gloom of the past two years starting to lift, being slowly replaced by a more positive tone.

What no-one following the oil industry can say with any confidence is how quickly the oil price will recover despite a near-uniform view that it will recover, eventually.

The man who has done most to boost confidence that the worst is over is Khalid al Falih, Saudi Arabia’s relatively new oil minister and a former chief executive of that country’s oil giant, Saudi Aramco.

Last month Falih provided a rare glimpse of how the world’s biggest oil-producing country sees the future, summed up in five words: “We are out of it”.

The “it” is the oil glut which caused the 2014 price crash, but even Falih declined to be more specific than to indicate that the worst is over.

The Saudi oil boss, and a graduate of Texas A&M University in the US oil capital, Houston, told the Houston Chronicle newspaper in the only interview since his appointment that:

“The oversupply (of oil) has disappeared. We just have to carry the overhang of inventory for a while until the system works it out,” Falih said.

“The question now is how fast you will work off the global inventory overhang. That will remain a cap on the rate at which oil prices recover.

“We just have to wait for the second half of the year and next year to see how it works out.”

Falih’s comments introduce time as a critical factor in the oil-price recovery, and the closely-connected revival of Australia’s oil and gas producers.

But, the good news is that achieving a balance between supply and demand was the first important step in the recovery process. Consuming the glut of stockpiled oil is the process now underway.

UBS reckons that the change from a growing glut to a shrinking stockpile is reason to upgrade its oil-price forecasts for Brent-quality crude to $US51/bbl for the rest of this year, rising to $US60/bbl next year, $US70/bbl in 2018, and then up to a long-term price of $US75/bbl.

Morgan Stanley is slightly more optimistic, lifting its long-term oil price from $US60/bbl to $US80/bbl from the year 2019.

If correct, the UBS and Morgan Stanley views of the oil price point to supply and demand conditions getting back to where oil was five years ago.

But, and this is important for investors, the cost structure of the oil industry is quite different to what it was at the time the oil price crash.

Heavy duty cost cutting has trimmed most of the fat out of the industry which should help oil and gas producers enjoy a profit recovery somewhat better than might be expected by looking only at the oil price.

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