European Oil & Gas: road to redemption
By James Hosie and Christopher Gordon, Barclays UK
The sustained low oil price during the last year has been a painful experience for the European E&P sector. But it has also been the catalyst for a much-needed change in mindset, prompting management teams to address the operational inefficiencies, bloated budgets and poor capital allocation that eroded returns and investor confidence before oil prices fell. We believe the results of these changes should begin to emerge in 2016 in the shape of a more focused group of businesses presenting strategies centered upon value over volume and capital-constrained growth. Our optimism does not depend on a sudden rally in oil price, rather a gradual recovery as supply/demand dynamics rebalance in the medium term and recognition from investors of the strategic and behavioral changes made.
We expect 2016 outlook statements to emphasise the ability to create and realise value while operating within the constraints of ~$50/bbl, potentially marking the first steps towards redemption. It is on this basis that we revise our industry view to Positive from Neutral. This report adds five new stocks to our coverage group – Amerisur Resources (OW), Det Norske (EW), DNO (OW), Faroe Petroleum (EW) and Ithaca Energy (OW) – and includes updated investment cases for the whole group. Ophir Energy remains our Top Pick, while DNO, Ithaca Energy and Tullow Oil, in our opinion, provide the most attractive investment cases to benefit from an improving oil price outlook and recovery in investor sentiment towards the sector. We have updated our valuations with a reduced oil price outlook, which leads to a more cautious view on future investment activity and reduced growth prospects in the medium term.
Our Tangible NAVs therefore drop by an average of 17%. The group is trading at an average discount to our base case Tangible NAV of 35%. Our new 12- month Price Targets are set at discounts to this base valuation, reflecting stock-specific oil price sensitivities, and imply average upside potential of 23%. At current oil prices, existing production within the group remains cash-generative, while ongoing developments should enhance these production portfolios in the coming years. This should enable the sector to pursue further growth at a moderate pace, while debt-levered operators can remedy sub-optimal capital structures. Although we recognise that debt refinancing and redeterminations continue to bring material risks, we believe misconceptions within the equity markets about the motivations of lenders has overstated the risks of a liquidity squeeze impacting cash-generative businesses that are demonstrating increased capital discipline and improving project execution.
Rating changes: We downgrade Cairn Energy to Underweight from Equal Weight and both Africa Oil and Premier Oil to Equal Weight from Overweight, all on the basis of lower implied returns relative to our expanded coverage group.