The flows fuelling oil stocks

Summary: There's a renewed interest in ASX-listed oil stocks. Deal flow, or speculation of, is a major reason for the recent increase in activity, as well as hope the oil price will rise after three down years.

Key take-out: Select mid-caps have risen on deal talk as of late, but investors could likewise note some larger companies are looking to part with their oil assets. With as many speculating an oil price recovery as a further slump, it's hard to decide what side of the buyer-seller equation to settle on.

Investor interest in ASX-listed oil stocks is returning, but not necessarily because of confidence in a sustained recovery in the price of oil, which remains stuck in a range of mid-$US40-to-mid-$US50 a barrel.

Deal flow, or speculation about a possible increase in deals involving oil and gas assets, is one reason for an increase in oil stock activity. Hope that the oil price will rise after three down years is another.

Neither reason should be sufficient for most investors to get overly excited about a sector that remains captive to international politics. There's also the underlying problem of a large stockpile of surplus oil and a market where supply continues to exceed demand.

Two stocks that have benefitted most from talk of company-changing deals are Beach Energy and Santos. Both were sold down heavily when the oil price crash started in mid-2014 and both have been through a period of significant management and operational change.

The next step, according to one theory, is that both will accelerate their revival process with significant acquisitions. Beach has been named a possible bidder for the Lattice Energy spinoff from Origin Energy, and Santos a possible bidder for WA-focused Quadrant Energy.

Neither deal is guaranteed but there are signs of growing interest in the Beach and Santos revival stories. Beach shares are up 10c (15 per cent) to 66c since mid-June and Santos up 83c (28 per cent) to $3.75 over the same 10 weeks.

Woodside, the energy sector leader whose been missing from recent deal talks, has at the same time slipped 44c, to be down 1.5 per cent from its mid-June price.

The price of Brent crude has picked up since mid-June to $US52.20/bbl. It looks to have had more of an influence on Beach and Santos than on Woodside, but the event which appears to separate the smaller companies from the leader is the potential for growth by acquisition.

The assets on offer to a bidder prepared to bet heavily on an oil price revival have a solid business base.

Lattice contains most of the small oil and gas assets of Origin which is shrinking its oil and gas interests back to its 37.5 per cent interest in the Australian Pacific LNG project in Queensland.

Quadrant, which operates an assortment of older oil and gas assets in WA, is a business controlled by Macquarie Bank and the Canadian property infrastructure investor, Brookfield. Neither is regarded as a long-term owner-operator of oilfields.

Action involving both the Lattice spinoff, which could be by float or trade sale, and Quadrant, is expected in the next few months – or possibly a lot sooner if the oil price moves higher.

The question for investors is whether now is a good time to be buying into an oil stock – or is it better to be selling? Certainly, management at Origin has decided to sell and the owners of Quadrant might be planning to as well.

Unfortunately, that question requires a view on the future price of oil, and on that problem, the jury is out. There are as many forecasts of an oil price recovery as there are of the oil price being capped at around its current levels for several years.

If either deal unfolds – Santos moving on Quadrant and Beach moving on Lattice – a lot will hinge on the determination of two men to complete the transactions: Kevin Gallagher, the relatively new chief executive of Santos, and Kerry Stokes, whose Seven Group is the biggest shareholder in Beach.

A former senior executive at Woodside and former chief executive of the Clough engineering group, Gallagher describes himself in Santos literature as a “turnaround specialist”, something he appears to have achieved since taking up the top job at Santos early last year.

But whether Gallagher is ready to make a significant acquisition, with a price tag likely to be around $4 billion, seems unlikely. Santos itself is currently valued at $7.8 billion.

A more likely outlook for Santos is a continuation of the internal streamlining already underway, including the likely sale of Asian oil and gas interests which could generate some of the capital for an expansion move, such as a bid for Quadrant.

Most recent investment bank research on Santos has included little by way of comment on deals, preferring to focus on improvements being made to existing operations and the effect on debt reduction and improving cash flow.

Investment bank Macquarie last week singled out debt retirement and cost cutting in Santos' legacy South Australian assets in the Cooper Basin as a highlight of the past 12 months as a primary reason to tip the stock as a ‘buy'.

Fellow investment bank UBS, which has a ‘neutral' view of Santos, also commented on the cost decline, but added a caveat that a recovery in the oil price was key to rerating the stock.

Beach is regarded as more likely to deal on assets than Santos, largely because Stokes has been clearing the decks at Seven with a number of asset sales underway that could provide the capital to underwrite a bid for Lattice.

Recent media reports suggest that Beach is talking to several banks about a major fundraising, perhaps as much as $700 million to provide the capital for a $1.4 billion offer for Lattice.

As has happened with early Stokes deals, Seven is said to be a willing underwriter, standing ready to soak up shares not acquired by other Beach shareholders. This is a process that should ensure the success of the deal and would probably lifting Seven's stake above its current 20 per cent.

Investment bank Credit Suisse, in a report circulated on Tuesday, September 5, praised the improvements achieved at Beach over the past 12 months which have included a unique double of boosting free cash-flow generation while replacing oil and gas reserves.

“It is hard to find many exploration and production companies globally that are sustainably replacing reserves and still generating around a 10 per cent free cash flow yield at (an oil price) of $US50/bbl,” Credit Suisse said.

The bank did not comment specifically on Beach chasing corporate deals, but did hint that something might be in the wind, noting that the stock was no longer dependent on “inorganic” opportunities – code for external deals to achieve growth.

“Where they [deals] are accretive and make sense, it is a cherry on top,” Credit Suisse said.

It now remains to be seen whether Lattice is a cherry that could substantially change Beach.

For investors, the key takeaway from the speculation about Santos and Beach possibly pursuing deals is that oil is making a return as an interesting investment option, after spending three years in the sin bin.

Nothing is a sure thing though – and whether it's best to be a buyer or a seller, given the health of the oil market, is currently a significant uncertainty.