Oil price finds sweet spot, while mining hits rock bottom

Glenn Freeman | 20/12/2016

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Glenn Freeman: I'm Glenn Freeman from Morningstar and I'm joined today by Mark Taylor, our equity analyst, covering mining services and energy stocks.

Mark, thanks for joining us today.

Mark Taylor: You're welcome, Glenn.

Freeman: Now, Mark, just firstly, can you just talk us through a little of what's happened to the oil price movements in the last few months and how that's played into Morningstar's assumptions?

Taylor: Sure. Well, the oil price has been trading in an approximate band of $45 to $50 for the back half of this year and there has been a lot of uncertainty as to whether it's going to hold. A recently announced million-plus barrel a day cut by OPEC has sort of set the market tone. It's become more positive.

There's a degree of confidence that the oil price is going to improve from $50 a barrel. In response to that we ourselves increased our 2017 oil price forecast from $50 a barrel to $60 a barrel, but we also see that in the longer-term potentially hurting prices because it's likely to incentivise shale gas production and consequently we've actually lowered our 2017 oil price forecast.

But our long-term forecasts of $60 a barrel is unchanged. We see that as the sweet spot where producers can make money and you're not going to incentivise too much production to lead to oversupply.

Freeman: Now, what effect has this movement had on some of the oil and gas companies in the local market?

Taylor: Well, we haven't seen a huge amount of actions share price-wise. There has been a gradual creeping up in prices in response to the announced cuts and improved prices. But really what it's going to mean is that earnings and cash flow next year are going to be much stronger than they were this year admittedly coming from a very low base. And I don't think it's going to be enough to set companies on a target of acquisitions and growth, but it will definitely make them feel a lot more comfortable about servicing balance sheets and perhaps looking at spending a little bit more money than they may have otherwise done.

We've certainly seen Santos already take advantage of the fact and has announced a $1.5 billion capital raising to ease some of the pressure on its balance sheet. So, potentially, those are the sort of things that you're going to see rather than a huge change in earnings. Just that the market being in a slightly more positive frame, it will create opportunities for non-core asset sales, raise a bit of money, this sort of thing I think.

Freeman: Now, Mark, mining services is another area that you cover and we've just recently put out a special report on this space. Can you just give us a few key points on what's covered?

Taylor: Okay. Well, we cover a number of companies in the mining services sector. It's an interesting term for a collection of companies that do a vast array of different things that all come under the same umbrella terminology-wise. But we see the mining services space generally as being overvalued.

Sector-wide, we think it's overvalue in the order of 35%. We think the market is way too optimistic on the likely impact for infrastructure spending by the government to replace the large hole that was left by the end of the China-driven mining boom. It's not to say that it's not positive. We ourselves are forecasting quite optimistic growth in earnings and revenues, but we just think that the market has got ahead of itself.

We think that the growth in the sector is not going to be coming from mining and energy, but rather non-mining and energy sources like government infrastructure spending on roads and rail and other niche areas that companies can operate in because there are similarities to mining, their skill sets still apply but they are not actually mining and energy based.

We don't see the decline in energy investment in Australia, for example, to hit a nadir until 2018 and that's because you've just got the tail end of this once-in-a-generation LNG construction boom still running its course. We're seeing mining expenditure bottoming a bit sooner in 2017. So, we're pretty much close to the low as far as mining spending goes, but a bit more pain in energy.

Freeman: And just lastly, we're now at the end of 2016. What do you see on the horizon for next year?

Taylor: I think, well, in mining services the market and the place to be watching is the degree to which public infrastructure spending starts to hit the bottom lines of those companies. I mean, there has been a lot of anticipation. It hasn't really manifested yet in earnings and cash flows. So, that's one thing to watch.

And our forecasts, as I said, are quite positive. So, we'll be watching that keenly to make sure that we're on the right path there. That aside, I still think you can expect fairly substantial pullback in mining services company share prices. We think they need to come back about 30 per cent before things start to look interesting from an investment point of view. But in the oil and gas names we think there's still value there and we see them improving next year as the market digests improving revenues and cash flows for those companies as they report.

Freeman: Mark, thanks very much for your time today.

Taylor: You're welcome.

Freeman: I'm Glenn Freeman from Morningstar. Thanks for watching.

 

This report appeared on www.morningstar.com.au 2017 Morningstar Australasia Pty Limited

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