Morningstar Cuts Oil Sector Share Price Valuations

Morningstar equity analysts have cut their estimates for oil groups across the board, following a downgrade of long-term oil and gas price forecasts

Morningstar Equity Analysts 19 March, 2015 | 10:14AM
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Our long-term oil price forecast has decreased to $75 per barrel (Brent) from $100, and our long-term US natural gas price forecast is now $4 per thousand cubic feet versus $5.40.

With respect to our long-term oil price outlook, the fundamental issue that has changed relative to our previous mid-cycle per-barrel estimates is the emergence of US tight oil. Although US production is showing in real time that quick supply responses are possible, any near-term slowdown does nothing to diminish the resource potential that is in place. We see any near-term declines in output as short-lived with declines set to quickly reverse as producers respond to price signals.

As a group, global integrated firms’ valuations and returns are meaningfully impacted by the reduction in our mid-cycle oil price, given their greater reliance on oil production and high levels of investment in higher-cost projects over the last several years. In the near-term, the impact on free cash flow will be especially severe given little flexibility in capital spending. However, beyond 2016 we expect flexibility to increase and spending to fall as management teams trim capital spending plans to ensure their dividends. Additionally, we expect international project costs to contract by 10% creating opportunities to reduce spending further.

The impact of that our oil price forecast reductions have had on our company stock valuations varies by company and subsector. 

BG Group – Valuation Cut to 1,200p 

Our valuation methodology incorporates three years of strip prices, with terminal prices defined by our longer-term oil and natural gas price forecasts. Our reduced fair value estimate for BG Group (BG.) shares of 1,200p apiece, versus 1,400p previously, also includes lower capital costs and operating expenses, based on our expectation for falling oil-service fees. 

As such, BG shares currently carry a 4-star Morningstar rating, implying the market is slightly undervaluing the stock. 

BP – Valuation Cut to 500p 

Given our view that oil prices won't fully recover any time soon, we don't believe BP's (BP.) assets are cost advantaged enough to generate excess returns on capital. Despite plans to lower spending and delay higher-cost projects, we believe the recent trend of low returns on capital is likely to continue indefinitely. Accordingly, we are lowering BP's economic moat rating (a measure of a firm’s ability to sustain a competitive advantage) from ‘narrow’ to ‘none’, and reducing our fair value estimate to 500p from 575p previously. 

BP carries a 3-star Morningstar rating at present, implying the market is fairly valuing the stock. 

Petrofac – Valuation Under Review

Morningstar’s equity research team is reviewing its fair value estimate for Petrofac (PFC), which was formerly 1,150p per share; an update will be provided shortly. 

Royal Dutch Shell – Valuation Cut to 2,100p 

We are lowering Royal Dutch Shell’s (RDSB) economic moat rating to ‘none’ from ‘narrow’ and reducing our fair value estimate to 2,100p from 2,200p previously. Our new valuation assumes Shell will be able to reduce capital spending (as well as capital intensity levels) and trim corporate and operating costs as the firm tries to right-size itself to better compete in a lower oil price environment. 

Shell shares now carry a 3-star Morningstar rating, implying they are fairly valued by the market. 

Tullow Oil – Valuation Cut to 410p 

We are lowering our fair value estimate for Tullow Oil (TLW) to 410p per share from 650p. Our valuation assumes Tullow will be able to reduce capital spending, benefit from capital cost deflation, and trim operating and G&A costs. 

Tullow shares are currently rated 4 stars by Morningstar, implying the stock is marginally undervalued at present.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
BP PLC412.70 GBX-2.28Rating
Petrofac Ltd157.90 GBX0.57
Royal Dutch Shell PLC B  
Tullow Oil PLC54.75 GBX-0.73

About Author

Morningstar Equity Analysts  Morningstar stock and fund analysts cover 2,000 mutual funds, 2,100 equities, and 300 exchange-traded funds.