Oil prices posted their strongest monthly gains in years in May in response to earlier supply cuts and gradual signs of global economic recovery.

Members of the Organisation of Petroleum Exporting Countries and its allies, known as OPEC+, are set to decide as early as Thursday whether to extend the production cuts agreed in mid-April.

Oil output was slashed as the agreement took effect from 1 May, falling by a record 9.7 million barrels per day—about 10 per cent of global output—to its lowest level in 20 years as Saudi Arabia and Russia finally struck a deal.

Reduced energy demand amid faltering economic activity have also led to a record low in the number of North American rigs pumping oil and gas. Oilfield services company Baker Hughes reported the number of rigs in the US was down 65 per cent between 13 March and 22 May.

But as Morningstar's Peter Warnes says in the latest Your Money Weekly: "Any economic recovery is energy dependent, and oil and gas will play a major role."

Warnes expects energy demand will gradually increase in line with rebounding economic activity.

"Don’t expect West Texas Intermediate prices north of US$60, but a price between US$40 and US$50 is certainly possible over the next two years," Warnes says.

"This would return the high-cost US industry to a positive free cash flow position on average and see most OPEC and non-OPEC members profitable."

Morningstar research highlights three Australian oil companies as buying opportunities at current prices, but Warnes reminds investors neither of them holds an Economic Moat and have high Uncertainty ratings.

Woodside Petroleum (ASX: WPL)

Morningstar Rating: 5-star | Price-to-Fair Value: 0.51

Australia's largest oil and gas producer, Woodside's "excellent balance sheet" and low costs leave it well-positioned to cope with lower crude prices in the near term, says Morningstar senior equity analyst Mark Taylor.

Even if oil prices sank as low as US$10 a barrel, "we expect the company could remain liquid for at least the next two years," he says.

Woodside's share price closed at $22.87 on Monday, almost 50 per cent below the $44.60 Taylor believes the stock is worth.

The US$11 billion Pluto liquified natural gas project in Scarborough, Western Australia is a key part of Taylor's fair value estimate, particularly the addition of a new production facility or "train". Construction work on T2 is already under way, with front-end engineering and design work already complete.

Each new train at Pluto adds more than five times the equity LNG output, and around 15 per cent of Taylor's $44.60 fair value estimate for Woodside is attributed to the completion of T2. He thinks it "inconceivable" the project won't go head at some stage—but the current share price suggests the market is far more sceptical.

"Gas has a rapidly growing role to play in fuelling the world no matter how optimistic certain renewable energy targets may be," he says.

Santos Limited (ASX: STO)

Morningstar Rating: 5-star | Price-to-Fair Value: 0.53

Woodside competitor Santos is trading at a similar discount, with a Monday closing price of $5.49 versus a $10.30 fair value estimate.

The second-largest domestic oil and gas exploration and production company, Santos holds a stake in each of Australia's hydrocarbon provinces, most of which are located offshore. It also has interests in Indonesia and Papua New Guinea.

Santos's first-quarter production figures of 17.9 million barrels of oil equivalent (mmboe) were slightly below Taylor's expectations, but the company's full-year output projections remain unchanged at between 72 mmboe and 80 mmboe.

"We project production to increase 70 per cent to almost 130 mmboe by 2026," Taylor says, also tipping revenue to grow at a compound annual growth rate of 7.5 per cent by 2029.

He highlights the company's US$265 million of free cash flow and declining net debt of 6 per cent for the first quarter of 2020.

The group's acquisition of ConocoPhillips assets, the bill for which is due during the second quarter, will increase net debt to US$3.1 billion from the current US$2.7 billion.

Taylor notes that the company's net debt-to-earnings ratio of 1.8 is "comparatively lofty", but he is confident this will dip back below 1 as early as 2022. He's also comfortable that none of Santos's debt covenants with its lenders is nearing danger levels—even when prices were at recent lows of below US$25.

Iraq oil refinery workers

Energy demand is expected to gradually increase in line with rebounding economic activity

Aussie energy's high-risk rating

Fair value uncertainty for both Woodside and Santos is high. In the case of Woodside, the company is heavily reliant on its Western Australian LNG operations: Pluto in Scarborough and the North-West Shelf joint venture in Browse Basin, off the coast of Broome. Together they account for around 12 per cent of Taylor's fair value estimate.

"We rate all Australian resource and energy exposures as being at least high-risk, including BHP Billiton (ASX: BHP), despite its greater commodity and geographical diversification, along with its increased scale advantages," Taylor says.

Santos faces environmental and operational risks—a given within the oil and gas industry— along with country-specific risks associated with some of its assets outside Australia.

For lower uncertainty energy companies, investors need to look overseas. Both Exxon Mobil and Royal Dutch Shell are both currently trading at substantial discounts to Morningstar's fair value estimates and hold Medium uncertainty in the eyes of our equity analysts.

Taylor suggests this is partly due to the broader integration of these offshore companies. Their operations extend right across the energy value chain from exploration and production, to refining and petrochemicals. Their greater size may also play a part—Shell has a market cap of US$121 billion, versus Woodside's US$14 billion.

Royal Dutch Shell

Morningstar Rating: 5-star | Price-to-Fair Value: 0.43

Narrow-moated Shell is currently trading 57 per cent below the fair value estimate set by Morningstar senior energy analyst Allen Good.

Good recently left his fair value estimate at GBP22.27 despite a sharp fall in first-quarter earnings to US$3 billion, from US$5.4 billion for the same period in 2019. The UK-headquartered company reports earnings in US-dollars, in line with the US pricing of oil and gas.

This result was expected, but the company's dividend cut wasn't, down 66 per cent versus fourth quarter 2019.

But Shell management cited the unprecedented level of uncertainty from coronavirus economic fallout, and said it wanted to set dividends at a sustainable level that left opportunity for future growth.

"This could ultimately afford Shell greater financial flexibility over the long term and allow for debt reduction and greater reinvestment," Good says.

The dividend cut will save Shell around US$10.5 billion annually.

Exxon Mobil

Morningstar Rating: 5-star | Price-to-Fair Value: 0.63

Instead of restraining capital spending, oil patch peer Exxon plans to boost spending to double earnings and cashflow from 2017 levels by 2025, targeting a 12 per cent return on capital.

Good notes that the plan is heavily reliant on market conditions, and suggests the timeframe could be extended in light of weaker overall market conditions.

But he agrees with management's view that the company's host of high-return projects can help drive its "superior integrated model".

"We have long argued, and the historical returns support our contention, that Exxon is the highest-quality integrated oil company overall and that its downstream and chemicals segments are key differentiators," Good says.

"It stands to reason it should invest to maximise those advantages."

Exxon's exploration and production operations will lead the charge. The group is targeting a 20 per cent return on capital from the upstream division.

Good notes discoveries in locations such as Guyana and acquisitions in Mozambique are tipped to contribute most of the additional 1 million barrels of energy equivalent per day the group is aiming for by 2025.

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