Energy stocks are cheap. Should they be on your watchlist?
Whitehaven Coal, Z Energy, and Beach Energy are among the 10 energy stocks under Morningstar coverage trading at big discounts.
Mentioned: Viva Energy Group Ltd (VEA), Beach Energy Ltd (BPT), New Hope Corp Ltd (NHC), Origin Energy Ltd (ORG), Santos Ltd (STO), Whitehaven Coal Ltd (WHC), Worley Ltd (WOR), Woodside Energy Group Ltd (WDS)
There are currently 10 energy stocks under Morningstar coverage trading at big discounts. In this article, we examine the pros and cons of three of the most undervalued energy names under Morningstar coverage: Whitehaven Coal (ASX: WHC), Z Energy (ASX: ZEL) and Beach Energy (ASX: BPT).
Source: Morningstar Direct; data as a 22 February 2021
Whitehaven Coal
Whitehaven Coal remains on the Morningstar Best Ideas list, with the shares trading at a more than 50 per cent discount to the $3.20 fair value estimate set by equity analyst Mathew Hodge.
Whitehaven Coal is a large Australian independent thermal and semisoft metallurgical coal miner with several mines in the Gunnedah Basin, NSW. It offers exposure to global energy and steel demand via thermal coal (used in electricity generation) and metallurgical coal (used in steelmaking).
Whitehaven also owns the large undeveloped Vickery and Winchester South deposits in NSW and Queensland respectively. Coal is exported to India and across Asia, with the exception of China.
Whitehaven’s share price has been on a rollercoaster, climbing as high as $5.90 in June 2018, and falling to as low as 86 cents at the end of August last year. And its recent first-half fiscal 2021 result was poor. Earnings fell 79 per cent compared to the prior half, reflecting the steep fall in its average coal prices from US$85 a tonne to US$63 over the period. It is currently at US$75.
However, the future is looking decidedly better, Hodge says, noting that poor first-half profitability does not reflect the company’s long-term earnings power. Its coal production is expected to grow to 18 million tonnes in 2023, from 10 million tonnes in 2014.
“Six months ago, the thermal coal price was around US$50 per tonne—and nearly all miners were losing money. This was not sustainable,” say Hodge. “We saw some supply cuts from producers such as Glencore in response. There has subsequently been a spike in demand because of the recovery from covid and a cold snap in the northern hemisphere, which has seen the thermal coal price rebound very strongly.
“There is a degree of scepticism as to how long lived this recovery will be. Whitehaven was north of $4 the last time the coal price was this high. If the coal price stays where it is—which we’re not factoring in—and earnings lift in the next half then you’d expect the share price to react.”
Import restrictions in China have also hindered seaborne thermal coal prices, but with other Asia demanding three times as much thermal coal as China, Hodge thinks trade flows have adjusted with more Australian coal flowing to other Asian customers.
“Margins have compressed with the lower coal prices and production disruptions at the key Narrabri and Maules Creek mines, the latter resulting in higher unit costs. We see margins improving as the coal price recovers to our longer-term assumption of US$74 per metric ton from fiscal 2022 and as cost-reduction initiatives and a recovery in volume lower unit costs.
“We acknowledge the potential environmental, social, and governance risk around coal mining, particularly the 70 cents per share of our valuation attributed to the undeveloped Vickery and Winchester South deposits, but we believe little value is being attributed to those projects. In the scenario where social licence for building new coal mines is lost, we would expect some benefit from higher prices due to the restriction on supply.”
Z Energy
Z Energy is New Zealand's largest stand-alone retailer of refined petroleum products and meets close to half of the nation's transport fuel requirements, serving both retail and commercial customers.
The company was formed six years ago when New Zealand company Infratil and the Guardians of New Zealand Superannuation united to buy Shell New Zealand's downstream fuel business.
Z Energy operates in a small retail and commercial transport fuel market, where price competition and fight for market share are fierce. For these reasons it does not carry a moat and has a high uncertainty rating, according to Morningstar senior equity analyst Mark Taylor.
Despite population and economic growth, fuel consumption has in New Zealand stagnated for more than a decade partly because of vehicle fuel efficiency gains.
“While coronavirus will be a temporary pressure on refined fuel demand, consequent current negative refinery cash flows have regardless led all local no-moat-rated integrated refined fuel retailers to rightly question their ongoing viability,” Taylor says.
Z Energy, Ampol and Viva are all reviewing their refineries, while BP has announced closure of its Kwinana refinery in Perth.
Since only three refineries remain, it’s unlikely they’ll close in the medium term, Taylor says, as the government is seeking some level of fuel independence for Australia. However, he assumes refineries will close and convert to import terminals by the end of 2030.
Taylor reduced his fair value estimate for Z Energy in December by 17 per cent to $5 due to an assumed increase in corporate costs—refining forms only a small part of its business.
Z Energy has the steepest share price discount, but its leveraged balance sheet may see some investors prefer Viva Energy, Taylor says. Ampol has strengthened and is in fair value territory.
Taylor sees Z Energy’s longer-term earnings potential as attractive including Retail margin improvement from a period of hyper competition, even before COVID-19 struck.
“Earnings margins have grown from NZ4.7 cents per litre in fiscal 2011 to NZ10 cents. This could sustain at a long-run NZ9.0 cents as a result of Z Energy's focus on branding, location, refurbishment and charging reforms,” Taylor says.
Beach Energy
Beach produces oil, gas, and gas liquids from several joint ventures in the onshore Cooper and Eromanga basins—an area covering parts of Queensland, the Northern Territory, South Australia, and NSW.
Oil is more generally a high-margin business, says Taylor, but Beach is not a low-cost oil producer, given its development-intensive operations, small fields, and the requirement to truck product.
Beach has historically derived much of its revenue from oil, including an average 70 per cent to fiscal 2016. But the three-year average oil revenue contribution to fiscal 2019 fell below 50 per cent as the company added more gas producing assets.
Beach merged with Cooper Basin joint-venture partner Drillsearch Energy Limited in March 2016, which increased equity production to about 10 million barrels of oil equivalent. This has since more than doubled to 28 million barrels of oil equivalent after it bought Lattice from Origin Energy in 2018.
“The primary source of competitive advantage for resource stocks stems from sustainably lower costs than peers. We don't think Beach currently qualifies on this front,” Taylor says.
“Pre-Lattice production was a meaningful 10 million equity barrels of oil equivalent per year, but operating costs are high in comparison with peers. Five-year average EBITDA margins of 45 per cent to fiscal 2016 paled beside benchmark Woodside Petroleum's industry-leading 70 per cent. Beach has improved to plus 70 per cent EBITDA margins but peers push 80 per cent EBITDA margins.”
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