Soaring prices for oil and natural gas are prompting investors to revaluate their investment thesis for once-unloved local producers like Woodside Petroleum and Santos, according to several analysts.

After posting negative returns in 2020 and lagging last year’s bull run, investors are piling into shares of Australia’s largest natural energy producers as oil and gas cargoes change hands at the highest prices in almost a decade. Woodside is up 46% this year and Santos has risen 18% amid escalating sanctions on Russia and a global supply crunch.

The boom in global energy markets has catalysed interest in Woodside, says Aaron Binsted, a portfolio manager at Lazard Australian Equity, which owns the stock. Markets are waking up to the possibility of elevated energy prices as supply weakened by years of underinvestment lags demand, he says.

“Before covid hit, Brent oil was at $68 and Woodside share price was at $35,” he says.

“Woodside is still below $35. The market is just catching up to prices consistent with the fundamentals of well-supplied oil markets, which was what 2017, 2018 or 2019 were.”

“But today, there has been structural underinvestment, exacerbated by the shock of covid. It means oil prices will be higher than we saw in the three years before covid.”

“All this is before we get to the current crisis [in Ukraine]. We think there is a lot here and it’s absolutely focused people’s attention.”

Morningstar equity analyst Mark Taylor draws a link between rising energy prices and rising share prices. He adds that unrealistic views about how quickly renewable energy would send fossil fuels into the dustbin of history are now being challenged.

Woodside (ASX: WPL) closed Wednesday at $33.20, a 17% discount to fair value. Santos (ASX: STO) finished at $7.78, a 24% discount to fair value.

Waves of global sanctions for Russia’s invasion of Ukraine are scrambling supply out of one of the world’s largest energy exporters. In the latest escalation, the US and UK announced on Tuesday they would ban imports of Russian oil. The European Union also released plans to reduce gas imports by two-thirds within a year.

Even before Tuesday’s announcement, traders were already “self-sanctioning” as non-energy related sanctions made transacting in Russian oil more difficult, according to a new report by Morningstar energy analysts.

“They [sanctions] have also made global businesses and financial institutions extremely reluctant to transact with Russia, even in ways not explicitly targeted,” said report lead authors Dave Meats and Allen Good.

Brent crude has risen 30% since the invasion, for a total 75.6% gain since last August. Liquified natural gas spot prices in Asia have nearly doubled since mid-February.

Russia’s invasion of Ukraine came days after Woodside and Santos reported triple-digit jumps in profit for the year ending 31 December 2021. To the extent today’s prices stay elevated, bumper profits both companies announced in February will continue, says Taylor.

Investment bank UBS expects oil markets to remain tight over the next 18 months as OPEC producers struggle to hit production quotas.

Both producers benefit from higher prices in the short term by selling spare capacity into spot markets, Morningstar analysts say. Woodside sells roughly 15% of total production on spot markets, compared to 6% for Santos, according to data from investment bank UBS.

Over time, elevated spot prices should flow through to the long-term supply contracts where both producers sell the bulk of their gas, says Dr Suhas Nayak, a portfolio manager at Allan Gray. Many natural gas contracts are also indexed to crude oil and benefit from higher oil prices. UBS data suggest Santos is more exposed to long-term contracts indexed to Asian natural gas prices.

Primarily a natural gas producer, the merger with BHP’s oil and gas assets will increase Woodside’s exposure to oil prices. Oil production is set to rise from 18% to 29% of total production.

Will renewables kill the fossil fuel star?

Despite the short-term gain, higher prices today are a risk for fossil fuel producers like Woodside and Santos if they encourage consumers to cut energy use or spur investment in renewable energy, acknowledges Taylor.

“The antidote to high prices is high prices,” he says. “It kills demand and pushes consumers to alternatives. If Europe wasn’t already on an aggressive path to lower fossil fuel consumption, this will accentuate it.”

Senior European leaders have vowed to cut reliance on Russian gas imports and fossil fuels in general. Germany is pledging to source all energy from renewable sources by 2035, up from its previous goal of “well before 2040.” On Tuesday, the European Commission announced plans to reduce Russian gas use by two thirds through renewable energy generation, alternate sources of gas and cutting fossil fuel use in heating and power generating.

However, the impact of a shift to renewables is unlikely to be material for Woodside and Santos, says Taylor. Dirtier fossil fuels such as coal or oil will be “first in the firing line”, he says. Natural gas produces fewer emissions when burnt and forms the bulk of both company’s output. Any transition to cleaner energy is also likely to be more expensive and take longer than optimistic forecasts, he adds.

Oil market in Iran’s hands

Morningstar energy analysts say record oil prices could rise further unless the US can strike a deal with Iran to replace Russian output that buyers are increasingly avoiding.

Western buyers are “self-sanctioning” and avoiding Russian oil as sanctions on major banks make transactions harder. That’s driving up oil prices as Russian shipments are rerouted to new buyers or left unsold.

Extra supply from oil cartel OPEC or US shale oil producers is unlikely in the short term, according to report authors Dave Meats and Allen Good. OPEC kept production plans unchanged at its 2 March meeting and US shale producers need time to ramp up supply.

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Barring an eleventh-hour deal that lifts sanctions on Iran so it can sell oil openly on global markets, higher prices are the most likely outcome, say the report’s authors.

“An Iran deal or demand destruction are the only real options to relieve price pressure. But the latter might take higher prices, meaning a 2008-type spike isn’t off the table unless a deal is struck.”

Negotiators are underway in Vienna to revive the 2015 nuclear deal with Iran, which would see US sanctions lifted in exchange for commitments to restrict its nuclear program.

In a separate bid to unlock supply, US officials visited the Venezuelan capital Caracas over the weekend amid reports they are negotiating with President Nicolas Maduro’s sanctioned regime over oil exports. Venezuela has some of the largest crude oil reserves in the world.