Stock Markets Price in Doomsday Scenario for Oil

Allen Good: Good afternoon.

Black: So, you’ve had a very busy sector to keep an eye on over the past couple of weeks. Can you tell us what’s been going on?

Good: Yeah, we’re really in an unprecedented territory. We’ve had a demand shock as well as a supply shock, which is really taking its toll on oil prices over the last few weeks. On the demand side, we’re obviously dealing with the fallout from the coronavirus where countries from EU to the US are shutting down. Travel is falling. People are working from home and so that’s taking a toll on oil demand and certainly, the expectations around when oil demand or how much oil demand might fall and whenever it might rebound are unclear at this point.

On the supply side, we’ve had a breakdown in OPEC-plus coalition whereby Russia left not agreeing to new reductions. As a result, Saudi Arabia determined that it was in his best interest, at least in the near term, to increase production as well. So, we have two of the largest low-cost producers in the world, Saudi Arabia and Russia, adding volumes to an already oversupplied market. As a result, we’ve seen oil prices fall from about $70 earlier this year to $30 currently. So, it’s been quite a decline. And certainly, oil and gas equities have reflected that as well.

Black: So, what is your outlook for the sector from here? Has this changed your rating on any of the oil stocks?

Good: Well, we have updated our fair values for the lower oil prices, but we continue to maintain our mid-cycle oil price assumption of $60 per barrel. That’s our assumption of the necessary price to incentivize adequate supply to meet long-term demand. So, we’ve only really changed oil prices and as well earnings and cash flow estimates in our models for the next two years. My coverage list of large integrated oils, for example, only fell about 10% on average, given those weaker oil and commodity prices, given that we continue to stay with the mid-cycle assumptions over the long term. So, we have updated our fair value estimates, but they have not fallen as nearly as far as what the market is pricing in, which really seems to be implying current market conditions, not only for the oil prices, but also low natural gas prices, weak downstream margins and weak chemical margins as well. So, theoretically, the market is pricing in a pretty pessimistic scenario into perpetuity for all these stocks.

Black: But obviously, when you’re looking at the market, you’re thinking 15 or even 20 years in the future at some points. Is that harder to do when there’s so much uncertainty?

Good: Well, we are struggling to go that far out. I mean, we don’t kid ourselves. We only have probably insight into the next few years. Our mid-cycle price is really an estimate of what the price will need to be to incentivize adequate supply to meet demand in about five to six years. So, when you think about 10 to 15 to 20 years out, certainly in the environment that we’re in now, where you are having greater adoption of electric vehicles as well as greater efficiency standards, the idea that oil demand will at some point peak and decline is certainly in the realm of possibility. It’s just a matter of timing. But we don’t quite incorporate that into our fair values, given it does remain a couple of decades out.

So, I would also offer though, however, that the market is relatively myopic, and they do tend to price what they can see into perpetuity. And so, that can create dislocations in value if commodity prices are above our mid-cycle estimate or in this case, well below. So, I would say that does create opportunity. Now, certainly, we continue to feel our way through this and the demand fallout from coronavirus is really yet to be known. It’s unclear whether the virus will plateau over the next month, two months, three months, whatever and how long a lot of these major global economic countries who consume a lot of the world’s oil will be shut down. So, there’s nothing keeping the oil from falling further and as a result, sending these stocks lower as well. However, we think over the long-term prices currently are well below our fair value estimates by an average of about 50%.

Black: But one of the things a lot of investors will be thinking about with this sector is the safety of their dividends, which they rely on these stocks for in a lot of instances. Might we see some cuts?

Good: I don’t think so. I mean, balance sheets seem to be in relatively strong positions currently. If we look at the integrated group debt to cap ratios ranging from about 12%, upwards of 30%. Now, certainly, those firms like a BP, which are closer to 30%, have a likely higher chance of reducing their dividend. But we think even for those firms, the ability to reduce capital spending, realize asset sale proceeds, and in times of really dire need, they ultimately can go back to the scrip dividend option as well to reduce their cash flow needs or cash flow draw for the dividend. So, given those options, we don’t see dividend reduction as a high probability event. In fact, we actually think most of these firms will be able to muddle through the next couple of years relying on those various levers to ensure that the dividend remains intact. And then, we would estimate the oil prices will recover at some point the next two to three years, in which point the free cash flow will be able to cover the dividend.

Black: Allen, thank you so much for your time. For Morningstar, I’m Holly Black.