In Part one of this sector sweep we argued that sustained higher oil prices were likely as production from the vaunted shale sector declined.
Exposure to higher prices has, however, been fiendishly difficult to find. In Part 2, we noted that the big four energy stocks on the ASX are now exposed to LNG rather than oil and that the historic link between LNG and oil prices – a quirk of history – is likely to end.
If the big four aren’t perfect proxies for oil, why not buy something that is? A universe of derivatives and ETFs has opened to retail investors in recent years and you can now get oil exposure through these structured products.
Oil ETFs and futures don't appeal
Services firms are higher risk
Two production ideas
We aren’t against ETFs per se; gold ETFs that are backed by metal are wonderful products for those inclined towards the shiny stuff. Oil ETFs are a different matter.
The most prominent product is perhaps the Betashares Crude Oil Index ETF which trades under the mischievous ticker of OOO. This ETF, however, tracks another oil index – the S&P GSCI Crude Oil Index.
Unlike GOLD, which is backed by real gold in a real vault that can’t be lent to anyone, OOO buyers have a promise to track an index that promises to track the oil price. It is an indirect way to capture direct exposure.
The S&P index, in turn, tracks short term oil futures rather than Brent or WTI. This means that investors pay a 0.7% management fee for the ETF and also pay for storage and delivery of product like any other futures contract. Costs build quickly to make this an unattractive way to get oil exposure.
The small guys
If the big end of the sector isn’t quite as oil heavy as hoped, what about the smaller end? Here there are more problems of greater consequence; a small resource base, balance sheet woes, high costs and high risks are just some of the reasons we prefer not to dabble in the smaller end of the market.
For those interested, though, the best of the smaller oilers is perhaps AWE, which has rapidly transformed its business in response to the price slump.
Long beset by cost overruns, lower than expected returns and poor exploration results, AWE has now simplified its business, selling its US shale assets for a tremendous sum, getting out of Indonesian gas, reducing exposure to the BassGas project and selling the declining Cliff Head oil project offshore WA.
The result is a better-quality business with a large onshore gas resource in WA and a promising oil project in Indonesia.
Proceeds from asset sales have repaired the balance sheet, which now boasts over $60m in net cash, and calls on capital have been slashed.
From next year, gas contracts that locked in low domestic gas prices will start to roll over and substantially higher prices will be reflected in results. Miserly returns of the past will improve.
The most exciting development comes from WA, where the largest onshore gas resource in 30 years has been discovered. With access to nearby pipelines and low development costs, the Waitsia gas project will be among the lowest-cost sources of supply in WA.
Combined with attractive west coast gas prices, this will be a high margin, long life project and, with additional development, AWE could increase expected output by a factor of 10. Joint venture partner Origin is currently selling its 50% stake in the project and AWE is well positioned to emerge as a buyer.
The Ande Ande Lamut oil project, offshore Indonesia, is also likely to be developed should oil prices reach our expectations. A joint venture with Santos, this is a 100m barrel resource that will need oil prices closer to US$70 to be profitable. If developed, AAL will double AWE’s output and add disproportionately to profit. Historically a gas producer, AWE is now leveraged to oil prices.
Table 1 outlines our valuation for the business and it is deliberately conservative. Waitsia output could climb considerably over time and AAL would be worth more once fully developed. A sum of the parts method suggests AWE is worth around $0.80 per share today.
Considering our conservative assumptions, AWE isn’t expensive today but nor is it cheap enough to buy. We have a refreshed recommendation guide and would upgrade around 60 cents. For now, HOLD.
The services guys
Of course, you don’t have to buy a producer to be exposed to oil. This market downturn has been accompanied by an unprecedented collapse of investment in new supply and, apart from shale producers, oil services firms have suffered more than anyone.
Locally, there are several candidates that might be worth looking at. The obvious one is WorleyParsons, a darling over the boom years and a giant of the industry. A provider of services, Worley is fiendishly hard to value and carries plenty of debt. With large competitors and even larger customers, margins that have halved over the past few years will be hard to lift. The business is still mired in losses and, on an EV/EBITDA of 8, doesn’t appear particularly cheap.
Another option might be more interesting. Matrix Composites is a manufacturer of riser buoyancy, the high tech material that encases subsea equipment used on offshore oil projects. Over the boom years, demand was high and revenue poured in; so much so that Matrix decided to build the largest syntactic foam (the stuff that makes riser buoyancy) factory in WA.
You can guess what happened next. Debt rose, sales collapsed and today Matrix is a fraction of its former size.
Revenue has shrunk and profits are less than $1m but the balance sheet is clean and Matrix is the lowest-cost producer of syntactic foam in the industry. Its products are cyclically depressed rather than obsolete and the company can afford to wait while demand recovers. It now trades at just 50% of net tangible asset value, which includes a new best-in-class manufacturing facility.
If oil prices rise, deep sea drilling will be among the first activities to return and revenue should once again grow. Matrix is too small for us to cover formally but it is among the best oil exposures on the market.
What if tiny, unprofitable services businesses aren’t your thing? There is another option.
The biggest … and best?
Who is the largest oil producer on the ASX? You might think Woodside, but no; the crown goes to BHP Billiton which produces over 250 million barrels of oil equivalent (mmboe) per year, more than twice Woodside’s 92mmboe. If considered alone, BHP Petroleum would be among the top 20 oil producers in the world.
Despite being the largest, BHP can be a problematic oil exposure. It is simultaneously among the world’s largest producers of iron ore, coking coal and copper, activities which dilute the exposure to oil. Yet the attractions of the oil business are clear and often underappreciated.
Unlike the smaller producers, BHP generates huge cash flow, boasts quality producing assets and, crucially, a large proportion of output (and an even larger proportion of profit) is oil. Woodside, though mainly an LNG business, has a significant oil business too but it lost money last year.
Last year, petroleum accounted for 35% of BHPs asset base, 25% of revenues and 15% of profit. The sheer size of the asset base – over US$40bn in all – means that any increase in returns has a meaningful impact on profit. Oil may not seem meaningful from last year's result but that can quickly change as prices rise.
BHP's profits are most sensitive to changes in the price of iron ore – a US$1 change moves profit by about US$150m – but it is also highly sensitive to changes in oil prices. A US$1 change in the price of oil will move profit by about US$60m. Iron ore prices matter to BHP, but so do oil prices.
A focus on BHP's underperforming shale assets often overshadows the fact it operates some of the most productive and lowest-cost conventional oil fields anywhere. BHP pumps conventional oil at a cash cost of under US$11 per barrel, placing it in the bottom quartile of the global cost curve and below industry giants like Shell, BP, ExxonMobil and Chevron.
The conventional oil business produces over 120 mmboe annually and, even at today’s lower oil price, still generates operating margins over 70%. BHP has used the slump to increase leases in the Gulf of Mexico and has significant lease holdings in the Caribbean and offshore WA. There is ample opportunity to increase output at high incremental rates of return.
Shales aren’t as lucrative: they account for more than 50% of the petroleum asset base but last year generated losses of US$1bn. BHP will never generate outstanding returns from shale but, given its enormous asset base, improving returns could be meaningful.
BHP holds the best shale positions in North America. In the Permian and Eagle Ford Shale it can generate cash flow at oil prices as low as US$15 and total output should rise beyond 100mmboe this year.
We’ve expressed scepticism about the long-term economics of shale wells. That scepticism carries a caveat: a business with a large balance sheet and huge resource position can extract profitable output at the right location and at the right oil price.
Shale is characterised by sweet spots – areas along otherwise homogenous shale rock where oil has been cooked and pressurized to perfection. BHP’s Permian and Eagle Ford Shale positions sit along such a sweet spot. They claim the best cost and pay back metrics in the industry and are the focus of BHP's shale empire.
We were perhaps hasty in our initial upgrade but buying cyclical businesses only makes sense in tranches rather than one go.
The world's pre-eminent miner also comes attached to one of the biggest oil businesses anywhere. It’s not a perfect exposure; the petroleum business is diluted by BHP's other mines but it isn’t lost among them. As oil prices recover and remain persistently higher, BHP's profits will rise materially. The biggest oil producer on the ASX is also the best. BUY.
Disclosure: The author owns shares in Matrix Composites.