The ASX oil shares represent good value after the price of black gold fell into negative territory. There's now the potential for industry consolidation, with suggestions Oil Search Limited (ASX: OSH) may be a tasty morsel for Woodside Petroleum Limited (ASX: WPL).
The oil price has been extremely volatile due to a number of issues. These include the disruptions from COVID-19, Middle East tensions and the supply/demand war between Saudi Arabia and Russia.
"Although the crude oil price has continued to springboard off its lows, it is likely to remain under selling pressure in the weeks and months ahead until demand rises by 30%," says Bell Direct market analyst Jessica Amir.
Amir notes WTI gained 23% in 2 days to US$16.94 as energy producers halted drilling at a number of oil rigs in the US and Canada, with active Canadian rigs now at record lows.
"That's settling investor concerns for now. But the oil price is likely to remain under pressure until production cuts kick in and demand bounces back," says Amir.
Production cuts are not enough to offset the demand glut and there are few underlying fundamentals to push the price higher. Bell Potter's analysis suggests the Brent price could see another sell-off and re-test the US$16.00 level in coming weeks and months.
UBS Equities' global head of mining Glyn Lawcock says the future price of oil is the billion-dollar question:
Most producers are struggling to make cash on an all-in basis. When most companies talk about cash costs they refer to wellhead costs, which is the cost to get it out of the ground. But there are many other costs associated with oil a lot of companies choose not to disclose.
Most Australian and global producers have cash costs in the vicinity of US$10 a barrel plus or minus of US$2. But this doesn't account for capital they need to spend to sustain their businesses, exploration spend to keep leases on foot, head office costs, interest costs and repayment of debt facilities. So a more accurate cost is around US$28 to US$40 a barrel or more.
The cash deficit predates COVID-19, says Merlon Capital Partners' portfolio manager Ben Goodwin:
Oil companies might have been generating accounting earnings but even before the coronavirus disruption roughly half US shale producers weren't generating cash. They needed capital to continue to drill new wells to generate growth. That capital was drying up and in the US active drill rates were down by 25% even before the virus. Our original schematic was loss-making US producers, which had been responsible for the majority of supply growth of oil in the last 10 years, would have reduced production to support higher oil prices.
Goodwin says demand for oil is down by a third to 70 million barrels a day since the virus crisis, which has produced significant excess supply. This is likely to exacerbate US shale producers' exit from the market. He adds:
[D]emand should recover as coronavirus impacts exit the market. Data from China is opaque, but it seems its economy is back to maybe 80% of pre virus levels. You wouldn't want to use that as a template for the rest of the world. But there are examples of economies looking at exit as opposed to lockdown strategy. Second virus waves aside, demand could start to recover. There's a lot of alphabet talk. You wouldn't expect a V-shaped recovery; maybe a U-shaped recovery. But demand could get back to maybe 95% of previous levels on as a normalised basis.
There are many levers at play in the oil market. Post COVID-19, people might fly less or drive more to avoid public transport. Workers coming out of unemployment might avoid buying electric vehicles and instead buy cheap gas guzzlers, which would be good for oil.
"We don't really know what the wash up will be. But if this serves to accelerate US shale exiting at a faster rate that could be a positive for all prices on a medium to longer term basis," says Goodwin.
Another variable is the potential for US President Trump to step in and support US shale oil producers.
"US oil and gas producers are 5% of total employment so this would save jobs for him. That's a risk at the commodity level," says Goodwin.
Lawcock argues the current oil price is untenable, saying "there's a lot to think about with oil. Sometimes industries and countries surprise you in how long they're prepared to run cash negative before making decisions to curtail supply. So we'll see."
All about balance sheets
What this means is oil producers need balance sheets with incredible strength. Aussie oil companies have different resilience levels in this regard.
Woodside is in the best position, having completed a substantial capital raising in 2018 for its Scarborough, Pluto Train 2 and Browse projects.
"Now those projects have continued to slip, they find themselves in the strongest position," says Lawcock.
Woodside also has balance sheet flexibility and a low cost core asset, as well as a requirement to replace declining production in the Northwest shelf facility.
Nevertheless, Goodwin notes Scarborough and Browse are not tier one projects:
They are more expensive because they are dry gas projects or more remote and you need to spend a lot on the pipeline to get the resource back to the coast. Although the liquefaction plant in Karratha is a positive versus a greenfield project that requires a liquefaction facility as well as the upstream gas drilling and rigs and pipelines.
Oil Search is at the other end of the spectrum.
"It's already put its hand up and admitted it mis-funded the Alaska project to some degree. The market's view is, while still a good project, it should have been equity not debt funded because it isn't cash generating," says Lawcock.
Oil Search has yet to raise funds for its PNG project, and probably never assumed it would need to in such a dislocated market.
Goodwin says Woodside may be looking at good projects or assets from other producers such as Oil Search, which has seen its share price sold off a lot more than Woodside.
"Buying Oil Search would be a way of extending Woodside's production profile, as opposed to spending on their own projects. I think they would make a better return doing that, notwithstanding they would have to pay a takeover premium," says Goodwin.
Foolish takeaway
For investors, the question is which stock to get into, Woodside or Oil Search, and at what price. Both stocks could come down should the oil price drop again, which might be a good entry point, assuming an offer is not forthcoming before then.
