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Why I’m avoiding Oil Search Limited shares

Credit: rabiem22

The Opec deal to cut the supply of oil has been received positively by investors. The price of oil has moved to its highest level since June. Brent now trades at US$52.50 per barrel. This has pushed Oil Search Limited’s (ASX: OSH) share price up by 15% since the deal was announced on 28 September.

Similarly, Woodside Petroleum Limited (ASX: WPL) and Santos Ltd (ASX: STO) have both risen by 11% since that date. However, even though the prospects for oil may be brighter than a couple of weeks ago, I’m still bearish about Oil Search.

An unlikely deal

The Opec deal was a surprise to many investors and had not been priced in. Therefore, in my view the rally in the price of oil since the announcement will prove to be short-lived. Saudi Arabia’s decision to cut the prices of some of its oil exports in the aftermath of the deal shows that it may not prove to be a lasting agreement. The details of exactly which Opec members will cut production and by how much still need to be finalised. This provides a degree of doubt as to whether a cut in production will be put in place.

Supply versus demand

Even if Opec finalises a deal to cut production, there will continue to be a glut of supply over the medium term. Opec’s production reached record levels in August and a reduction of 700,000 barrels of oil per day (bopd) is unlikely to have a major effect on the oil price. Demand growth is forecast to remain weak over the medium term. The oil market may take until late 2017 to return to equilibrium according to the International Energy Agency (IEA).

LNG

It’s a similar story in the LNG market. Oil Search’s 29% stake in the Papua New Guinea LNG project may have long term growth potential, but LNG prices could fall over the medium term. The global supply of LNG is expected to rise by 50% over the next four years as 130 million metric tons of LNG come onstream each year between now and 2020. The LNG market is already oversupplied and LNG prices could therefore continue to struggle.

Alongside this is slow growth in demand. Japanese imports of LNG have fallen by 6% in the first seven months of 2016. Likewise, South Korea’s demand for LNG has risen by only 3% in the first eight months of 2016. As the two largest importers of LNG in the world, Japan and South Korea’s lower-than-expected demand for LNG does not bode well for its price potential in my view.

Outlook

Oil Search has made progress by improving its operational performance. For example, it reduced unit production costs by 8% to US$8.21 per barrel of oil equivalent (boe) in the first half of the 2016 financial year. This helped Oil Search to maintain positive operating cash flows.

Further, it will implement a strategy refresh which could create more cooperation between the PNG LNG and Papua LNG projects. Although this could boost its operational performance, the bearish outlook for LNG and oil prices means that I’m avoiding Oil Search.

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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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