RBC Capital Markets analysts Al Stanton and Nathan Piper have cut their 2008 WTI price forecast from US$120/bbl to US$105/bbl, however, they maintain their 2009 and 2010 oil price forecasts of US$90/bbl and US$85/bbl, respectively. Both analysts also expect UK gas prices to remain high through the winter, before falling back with the oil price. They note that the rapidly escalating US dollar – “the rapid swing from US$2.00/£ and parity with the Canadian dollar” has markedly increased the valuations of a number of international producers and explorers.
Assessing the current environment, Stanton and Piper see a trend emerging where “Undervalued and under-financed companies” fall victim to larger, well financed companies.
Among the developers, many of which have been plagued by development delays and funding shortfalls, the following stocks look primed to benefit from an increase in production and cash flow: “Niko Resources (D6 oil and fields offshore eastern India), Ithaca Energy (Jacky in the UK), Coastal Energy (Songkhla offshore Thailand) and JKX (Souyz pipeline tie-in in Ukraine).”
Among the explorers, Stanton and Piper highlight the following stocks “Tullow Oil is undertaking drilling campaigns in Uganda and Ghana that have the potential to transform the company's valuation. In the UK, Sterling Resources is drilling the Breagh East structure, which has the potential to be the largest gas discovery to made in the UK for a number of years, and Oilexco will appraise its high-profile Huntington oil field.”
Stanton and Piper find that international midcap oils are being valued at “an average discount to NAV of 33% and the small cap oils are trading at a 50% discount.” Following the sector’s slump, Stanton and Piper believe that M&A should pick up and “focused, deeply discounted, stocks such as Ithaca Energy, SOCO International, DNO International, Antrim Energy and Gulf Keystone, could be vulnerable to unsolicited approaches.”
Moving along, Stanton and Piper outline 3 ‘what next’ scenarios –
Base Case: "Keep the Faith for 12 months" (60% probability) Not unlike 2005/2006, the analysts foresee the sector to decline with the oil price over the remainder of 2008 and perhaps into Q1/09, while the oil price recovers through 2009, Stanton and Piper anticipate the E&P sector to remain weak at the outset but eventually recover with the commodity price. While the price of oil is down well from its peak but above historic norms, in contrast to 1998, cash flows and balance sheets are predominantly robust. This scenario assumes oil bottoms around US$85/bbl.
Scenario 2: "Short term (3 month) pain for near term gain (within 12 months)” (35% probability) The sector continues to follow the oil price and investors keep the faith that oil prices will remain above historic norms like in 2006/2007. With the international E&P sector having undergone a severe correction and hovering nears its lows, a year end rally should carry it into 2009. This scenario assumes that the worst of the correction is over and oil bottoms at around US$100/bbl.
Scenario 3: "Unloved, disconnect with any oil price recovery for over 12 months" (5% probability) Between 1999 and 2001, the oil price was low in absolute and relative terms, causing investors to desert the sector. While interest was slow to return, it was “Cairn Energy's (CNE.L) billion barrel success in 2004 that really ignited the sector again. Industry replaces equity investors and M&A activity increases materially.” This scenario assumes a prolonged global slowdown with oil prices sub-US$70/bbl.
So How Should Investors Position Themselves?
In the near term, Stanton and Piper believe that investors should focus on companies that are actively drilling, able to deliver material news flow and potentially outperform. Stanton and Piper pinpoint these companies to be “Tullow Oil, Coastal Energy, Oilexco and Niko Resources.”
As the oil price stabilizes, Stanton and Piper would look to “cashflow/production focused stocks like Addax Petroleum, Oilexco, Gulfsands Petroleum, JKX Oil & Gas, which should lead the rally when the macro environment improves.”
In the intermediate term (in scenario 3), Stanton and Piper are interested in smaller companies that might get taken out but larger players. Stanton and Piper focus on companies that have significant takes in significant projects, such as “Ithaca Energy, SOCO International, Oilexco, Antrim Energy and Coastal Energy.”
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