What next for oil and gas companies?

-- | 06/01/2021

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Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Allen Good. He is an equity analyst at Morningstar. Allen, you've been looking at the oil and gas sector and the giants in this industry in particular. Can you tell us what's happened for this group of companies in 2020?

Allen Good: Well, obviously, the big news was that oil prices crashed with the outbreak of the coronavirus pandemic earlier this year. Certainly, most countries around the world went into some form of lockdown, which put a cramp on demand and resulted in massive oversupply and as we see now, a crash in oil prices. But they were no more affected by the crash in oil prices than other oil and gas producers. I think the key thing that ultimately came out of the crash in oil prices in the coronavirus pandemic was that we've seen a lot of the integrated oils, particularly the Europeans, end up accelerating their plans of a transition to the new economy, in other words, to accelerate their plans to move to a low carbon integrated energy business as opposed to one focused on oil.

Black: So, thinking ahead to 2021 now, what are the challenges for this industry?

Good: Well, I mean, I think 2021 would be better than 2020. That said, if you look globally, the coronavirus pandemic is still raging. We do have some vaccine announcements, but they should take some time to roll out. We anticipate a continued economic recovery as we move through 2021. We'd estimate that this results in an improvement in commodity prices throughout the year. However, that does mean that it's still going to be a rather tough year for oil and gas groups, particularly the integrated oils.

Black: And let's take a look at some of the positives. What are the tailwinds and the opportunities in this space?

Good: Yeah, I mean, I think it depends on what the ultimate strategy is. You have firms like Exxon in particular who are more focused and continually focused on pursuing oil and gas investments. The amount of underinvestment that's currently taking place in the industry could ultimately prove to be opportunistic for Exxon as they look to increase their production, particularly from low-cost resources like Guyana. So, just as these resources are ramping up in the next few years, you could have a situation where demand is returning back to normal levels and then you have a dearth of supply as investment is falling off. And so, ultimately, you could be looking at a situation where you get much higher prices as supply is insufficient to meet demand. So, for those firms like Exxon who have not necessarily pursued the low carbon route and instead continued to bet on oil and gas, you could see them being in a very strong position over the next few years.

Black: And can you tell us some of your top picks in the sector?

Good: Yeah. So, I mean, if you—all our valuations are based off of DCF valuations using our $60 per barrel midcycle oil price. Assuming those factors, most of the group is significantly undervalued. However, I'd highlight two names in the integrated oil space which I think stand out. One would be Exxon, which is particularly cheap. It's sold off in response to its greater investment plans and its investments in oil and gas. However, as I mentioned, I think this actually creates an opportunity then for differentiation a few years down the road as the (interim) investment does ultimately lead to higher oil and gas prices as well as refining margins.

The other one I would point out is Total. Total has a relatively strong balance sheet. It's been able to maintain its dividend in contrast to peers such as Shell and BP. And so, it certainly has outperformed thanks to that, but it does support a higher dividend, which we think is sustainable given its relatively low balance sheet and the expected increase in oil prices that we see over the next couple of years. And it's straddling the line between investing in low carbon, so it is pursuing renewables. But it's not completely moving away from oil and gas either. So, I think the mix of their strategy and by continuing to grow their oil and gas while concurrently growing their renewable generation is a good mix that should leave them well positioned regardless of the commodity price environment or the long-term outlook for oil and gas investments.

Black: Allen, thank you so much for your time. For Morningstar, I'm Holly Black.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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