Why gas prices are on a tear
Liquefied Natural Gas prices collapsed early in 2020 due to the COVID-19 pandemic. However, factors such as an Asian cold snap, northern hemisphere winter demand, shipping constraints, China recovery post COVID-19, and higher Korean demand due to nuclear generation outages led to severe supply tightness. This led to a surge in the LNG netback price from historical lows of around A$2.30/gigajoule in mid 2020 to current prices at over A$8.
Arguably Australia’s own gas supply problems are more acute because of the huge Queensland LNG developments done by giants such as Origin Energy (ORG) and Santos (STO. This has tightened resources for domestic consumption. Australia’s huge supply shortfall is highlighted in this graphic:
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With many existing gas fields in decline, supply is having to be replaced from new projects that are under development and committed. However, from 2023 replacement gas will be required from anticipated projects that may still be in the planning stage but are not yet committed. Based on known potential projects, supply could begin to fall short of demand by around 2026.
What about oil? Following the steep drop in oil prices in March/April 2020, there has been a sharp recovery, which is likely to move higher. The incoming Biden administration in the US wants to see higher oil prices because it will make green energy seem cheaper.
The supply side looks good from a price point of view. Many oil companies are diversifying into renewable energy, which may mean there are fewer new oil projects. COVID has caused capital spending on oil projects to be deferred which has also reduced oil supply just as demand is recovering. Upstream spending has fallen 30% from 2019 and is expected to remain low in 2021. US rig counts in the US shale oil industry declined by 60% in 2020.
A small cap oil and gas producer amid transformation
One of the elements we look for in a Small Cap is business transformation. The good news is that we’ve found a small company in the oil and gas business, which is projected to more than double its oil production over the next two years after making a cut-price acquisition. We covered this stock late in January and you can find out about it by going Under the Radar.
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Energy stock idea: Cooper Energy (COE)
Speaking of transformation, Cooper is in the box seat to be a key supplier to South East Australia where it believes the market opportunity is 70 petajoules (PJ)/year by 2023 and over 100PJ/year by 2024. 1 petajoule is the equivalent of powering about 19,000 homes for a year. Utility customers include AGL Energy, Energy Australia and Alinta Energy.
Cooper is now at the beginning of contracted gas sales, which is no mean feat considering the major problems management has had to deal with. These centre around the APA owned and operated Orbost Processing plant for Cooper’s flagship offshore Sole gas field in the Gippsland Basin, Victoria.
As indicated, Cooper’s progress has not been linear. Most recently, gas production was temporarily lower in the December quarter due to down time associated with reconfiguration of the plant. This contributed to a weaker share price. However, following the changes, production is expected to increase to a sustainable 45 TJ/day and achieve 68 TJ/day over time. Annual contracted gas volumes of 19.75PJ in 2021 are expected to lead to a step change in revenue and cash flow.
Operational problems aside, when it gets it right, the problem will be where to put all the money! This is a company with a market cap of just over $600m, which is on track to ramp up revenues from under $80m in FY20 to over $300m in FY22. Moreover, costs are sunk and much of this drops to the bottom line.
Origin Energy (ORG)
At the big end of town our Blue Chip Value model likes Origin Energy, which has the ability to ramp up LNG production to take advantage of higher prices with gas production techniques supported by artificial intelligence.
This is through its 37.5% interest in Asia Pacific LNG, held within its Integrated Gas division. In November 2020 it achieved record operated asset production of 1,614 terajoules/day. With strong demand translating into long-term contracts, Origin has increased FY21 production guidance from 650-680 petajoules to 675-705PJ.
The company is experiencing pressure on earnings, an announcement this week highlighting that its retail business is generating lower profits, driving a 13% downgrade in FY21 earnings (EBITDA) guidance. This comes on top of Origin’s underwhelming profit for the December quarter.
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Over time we believe that higher LNG prices boost its bottom line, as will continuing production increases. On the retail side, Origin is on track to deliver cost reductions, some of which through its disruptive distribution platform Kraken, owned by Octopus Energy (Origin has a 20% stake in this company).
The time to buy is not when everything is going hunky dory, but when current difficulties obscure future profit growth.
As I write Worley’s stock has been hit hard in the wake of a profit downgrade due to ongoing COVID-19 related project deferrals. The company expects these projects to return as global economic conditions improve. There have been negligible project cancellations. This underlines how volatile the contractors earnings are, but also how there are opportunities for investors who appreciate value.
Moreover, Worley has broadened out its offering to beyond oil and gas says it is seeing profit potential accelerate across all its sectors. We believe current share price weakness provides a buying opportunity.
We like the exposure to energy (both oil & gas as well as renewable) the engineering contractor introduces to our portfolio because our model rates it as good value based on our high price target, which reflects its strong growth profile. Moreover, there is much less risk than pure energy plays because of its diversified income streams and technical expertise.
Worley also has a strong position in green energy as the world’s most influential economies have moved to explicit targets to achieve net-zero carbon emissions. The International Energy Agency estimates investment of almost US$3tn per year to 2030 in sustainable development.
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Worley’s core competencies now include offshore wind, where international oil companies, utilities, and investors are looking to expand. Worley currently has 25% of the UK market and 15% of the European market in this sector.
APA Group (APA)
Another stock that reduces your overall portfolio and is good value at current levels on our Blue Chip Value model is the pipeline operator. The company has a strong defensive asset base and balance sheet, which gives it the ability to fund more infrastructure investment.
Late last year the company announced it will invest up to $460m to construct a 580km pipeline in WA connecting the emerging gas fields in the Perth Basin to the resource rich Goldfields region, forming an interconnected WA Gas Grid, expected to be operational mid-CY2022.
APA has growth potential and offers a dividend yield of over 5%. With all this uncertainty, here’s a stock with a monopolistic position to consider.