Equilor Industry note_Oil and gas

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EQUILOR RESEARCH

01/09/2016

OIL AND GAS – INDUSTRY NOTE

Oil prices are expected to appreciate into a $50-60 per barrel price range next year. Strategy shifts implied, all integrated companies are implying cost-cutting schemes and

lowering capex. The future of oil might not be oil at many companies, as major players start to shift towards

gas based operations. Shale producers in the US, Shell and Eni in Europe and MOL is highlighted to have potential

despite the low oil price. Oil price has appreciated from its all-time minimum at the beginning of the year, and now trading in the 40-50 region as the supply pressure has weakened. The two major output interruptions, that had a positive effect on the prices, were the Canadian wildfires and the military operations in Nigeria. The two combined account for a 3.75 MMBOEPD output loss, the Nigerian daily production levels decreased by more than 50% due to the interruptions. In addition, the nomination of the new Saud Arabian oil minister had a slight positive effect on the prices; however the output targets of the country were left intact. Output actually reached record levels lately, which was the main force pushing prices back. In order to see a significant upward shift in the prices, we should wait for an OPEC output limit announcement. The board of the organizations is meeting twice more this year. First, at an informal meeting in Algiers between Sept. 26-28 and then at an OPEC general meeting in Vienna on 30th Nov. However, the internal conflicts can significantly delay any kind of agreement among the member countries, therefore the meeting in September is not expected to bring any major improvements. In terms of the future, even market participants have various expectations. The only agreed fact is the slow appreciation of prices, which all parties look forward to. They all expect prices to stabilize over the upcoming period although the price at which this happens is not clear yet. As per Table I below, companies expect a $50-60/barrel price however their strategies enable most of them to operate confidently under lower prices as well. Note that due to the rising prices the additional supply sources might result in a lower than expected equilibrium oil price.

Monika Kiss Head of research (+36) 1 808 9212 [email protected] David Farkas Analyst Intern [email protected] Oil price


Source: Bloomberg The oil price slump resulted in serious strategy changes among integrated companies. Investments among the industry fell by 30% in 2015, and if this year concludes similarly, it would be the first time investment falls for two consecutive years. All major companies are focusing on cost cutting, which results in the industry wide upgrade of assets instead of the construction of new ones. This is also the reason why OPEC’s move to weaken American shale suppliers seemed to fail for the first sight. As you can see on the graph above, the BAKEOIL index represents the falling number of working US oil rigs, while the rising US output is shown by the CROMUS index (light blue line represents crude oil price). It is clear that the remaining upgraded rigs could keep up the growing output which only started to fall as prices continued to decrease as well. These processes impacted smaller firms significantly more heavily; many hedge positions got exercised and free cash flow reserves have dropped significantly. These drawbacks are also dangerous from an M&A point of view, as they can become potential targets for bigger companies, serving as ‘cheap’ growth options. However, there seems to be no acquisition wave in sight as credit ratings for big companies have also suffered from the oil price decrease and number of desirable companies on the market is limited. The rebound in investments is expected to happen under a $65-75/barrel oil price scenario. Many shale producers are likely to switch their plants back on at this level, and companies running on break-even would also be able to report growing earnings. In addition this would increase the trust of credit providers in the industry, resulting in new funds for revving up investments. Therefore the first potential companies showing growth are expected to be the shale producers of the US, who are more flexible with switching their plants on and off as the prices change. Well known integrated companies cannot cope with these flexibility levels, therefore their growth rate cannot be directly compared. The table below shows data for major companies among the oil and gas industry in addition to significant shale producers (under the line).

Changing environment Growth potential


Table I. – Oil and Gas Industry – Year to Date (Share prices as of 31.08.2016.)

Company Country Current share price

Share price

change YoY (%)

Bloomberg consensus

target price

Net debt / EBITDA

2015 Adj. EPS YoY % change

2016 Adj. EPS YoY change

(forecast)

Oil price exp.

MOL HU 17330 21,57 18 152 HUF 0,74 + 158,13 + 22,80% OMV AU 25,12 - 3,62 23,40 EUR 26,80 + 1,09 - 44,53% 40 USD (2016) PKN PL 65 - 3,63 69,97 PLN 1,16 – + 30,40% Shell NL 1942 22,94 1960,50 GBp 1,1

4 -

52,73 - 41,40% 60 USD (2017)

Eni IT 13,54 - 2,17 15,45 EUR 3,23 - 91,04 + 56,30% 50-55 USD (2017) Exxon Mobil US 87,14 11,21 90,30 USD 1,13 - 49,34 - 28,60% BP UK 33,86 7,74 460,48 GBp 3,92 - 50,91 - 36,80% 60 USD (2017) Chevron US 100,58 11,46 111,84 USD 1,57 - 68,63 - 59,40% Total FR 42,75 3,60 47,36 EUR 1,46 - 5,59 - 30,26% Repsol ES 12,04 21,64 12,33 EUR 25,4

3 + 4,48 - 25,60% Continental Resources US 47,96 107,75 51,59 USD 4,67 – - 152,7% 72 USD (2016) Pioneer Natural Resources

US 179,05 42,53 202,98 USD 2,01 – - 74,70% 55 USD (2018) Diamondback Energy US 95,25 41,03 107,33 USD – - 19,20 - 42,80% Industry average 1,30 -51,0 -29,6% 50-60 USD

The expectations towards the shale industry can also be verified with the figure below. The relative performance analysis clearly places the shale producers to the best upright position. The only company on the right half over the line is Pioneer Natural Resources, which is one of the many independent US producers. Integrated companies tend to lag behind, however Shell and Eni are able to show over average EBITDA growth expectations while having technically the same EV/EBITDA rate as their peers. Interestingly these two companies happen to have the best outlooks for their gas based departments about which you can read our analysis below. In the CEE region MOL is clearly taking a more defensive position, while their financials are reported to remain strong. PKN however has some major issues, and is not expected to be able to continue growing without external support. According to the latest news the Polish government is going to buy a large sum of the shares in order to help out the company.


Many companies have failed to cope with the conditions. In the Northern-American region about 80 companies have filed for bankruptcy since 2015. Most of these were highly leveraged shale producers, biggest names include Aztec Oil & Gas, Linn Energy, Penn Virginia and Energy XXI. The latter was the biggest independent player in the Gulf of Mexico, it has filed for bankruptcy after spending billions on investments. The main problem among most of the firms was caused by the exercised hedge options, which left them exposed to the oil prices and caused them to start burning cash. The total debt stuck in these bankrupted companies reaches $66.5B. Many companies still in the market increased their debt in order to support their cost cutting strategies. However, in many cases these funds are directly used to maintain dividend levels in order to keep up investor attention. Besides these steps many companies are trying to further diversify their product portfolio, as conventional hedge options are becoming less effective under low oil price conditions. As it can be observed on the graph below, major companies (except BP) have significantly increased the share of gas based operations, which is comprised mainly by gas extraction and spot market sales. This energy carrier is relatively hard to transport overseas, therefore there is no global price identified as there is for oil. As a result having a well-positioned field can easily have above average financials prospects, which makes it a desirable alternative for oil. In addition its lower overall CO2 pollution level, lower investment costs and lower cost of switching plants on and off are all advantages over oil. Flexibility of companies having higher share of gas is increased, especially with the rising share of LNG (Liquefied Natural Gas), which provides a solution for easier transatlantic shipment. The share of gas based energy generation is expected to grow by 5% this year, which is mainly the result of the switch from coal-based plants.

Some fell short Shifting towards gas


Source: Bloomberg Shell and Eni have the brightest potential in terms of their gas departments. Beside their solid financial outlooks, both companies have significantly raised the level of gas operations showing they are bidding on gas. Eni lately announced a major gas discovery in Egypt, which the CEO identified as a game changer for Egyptian, and maybe even for European energy security over the long-run. Other companies (Chevron, Total) also show change in their resource mix. However their financial outlooks are not promising enough to make the most of gas. MOL also has issues, as their domestic market for gas is heavily limited by governmental measures. Shell CEO said in an interview that the growth of gas might also be supported by the change in the main fuel for transportation. He pointed out that the electrification of shipping and the heavy truck transportation might come later as expected, therefore gas could be a great bridge fuel. In this scenario gas would not only serve as a hedge, but also a lucrative part of the energy mix of integrated companies. In the middle -and long-run the oil and gas industry has plenty of potential. Companies are argued to be hit heavily by the effects of the lower oil price, and the lowered amount of investment towards exploration operations is expected to result in a slump of supply in the future. This would result in the appreciation of the share prices not only among shale producers, but also of integrated operators, especially the two highlighted companies, Shell and Eni.

Shell and Eni Summary


Research: Monika Kiss Head of Research Direct: (+36 1) 808 9212 [email protected] Laszlo Illes Senior analyst Direct: (+36 1) 436 9531 [email protected] Balint Kovacs Analyst Direct: (+36 1) 430 3452 [email protected] Zoltan Varga Analyst Direct:(+36 1) 436 7015 [email protected]

Institutional sales Marton Csintalan Sales Trader Direct: (+36 1) 436 70 14 [email protected] Attila Jozsef Szabo Sales Trader Direct: (+36 1) 808 92 00 [email protected]

Equities Department Zsolt Vavrek Equities Department Director Direct: (+36 1) 430 3991 [email protected] Private Banking Bertalan Nagy Private Banking Director Direct: (+36 1) 436 7019 [email protected]

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Equilor Industry note_Oil and gas