Oil Search Limited's (ASX: OSH) share price surged by 7% yesterday. This was due to an agreement between Opec countries to limit crude output. Gains were made across the oil and gas sector. For example, Woodside Petroleum Limited (ASX: WPL) and BHP Billiton Limited (ASX: BHP) rose by 7.3% and 4.7% respectively. However, in my view the long term outlook for Oil Search is bearish.
Supply glut
The deal between Opec countries will limit production of crude to a range of 32.5 million – 33 million barrels of oil per day (bopd). This is only slightly lower than the current output of 33.24 million bopd. Therefore, the current imbalance between demand and supply will still take time to rebalance. According to the International Energy Agency's (IEA) Executive Director, demand is now 'weak, weaker than many thought'. Without a larger decrease in supply than that announced yesterday, the oil market may not rebalance until part way through next year.
The individual production levels for each country will be agreed at Opec's 30 November meeting. This brings a degree of uncertainty to the deal, since the specifics have not yet been finalised. Given Opec's track record of failing to adhere to agreed upon quotas, changes to the deal could yet take place. In my view, this makes the near term outlook for the oil price highly uncertain which could hurt Oil Search's share price.
LNG challenges
Alongside an uncertain outlook for oil, Oil Search faces challenges in the liquefied natural gas (LNG) market. Over the next four years, the global supply of LNG is forecast to increase by over 10% per annum. A large proportion of this supply will come from 130 million metric tons per annum of approved new LNG capacity.
This increase in supply is likely to more than offset a planned increase in demand from China. It is aiming to replace around 400,000 small-scale coal boilers by 2018 in order to improve pollution levels. However, uncertain demand levels from the two biggest importers of LNG, South Korea and Japan, means that higher demand from China may not support LNG prices as expected. Both Japan and South Korea have increased demand for coal in 2016, which has reduced their demand for LNG.
Outlook
Oil Search faces an uncertain future due to continued imbalances in the oil and LNG markets. Its lack of diversity among other commodities means that falling prices for oil and LNG would have a direct impact on its profitability. Oil Search has a forward P/E using 2016's forecast EPS of 64, which falls to 27 using 2017's forecast EPS. In my view, this does not price in the level of risk from falling commodity prices. Therefore, I believe that Oil Search should be avoided in favour of these three blue-chips.
