Morgan Stanley Broker Note3 Jun 2020 21:41
Near-term oil price increases and rising inflation provide an opportunity to invest in E&Ps. However, considering future FCF, liquidity headroom, portfolio quality and near-term share performance, we recommend playing this through Aker BP – our only Overweight in the E&P sector.
E&Ps provide leverage to near-term oil price increases … The rapid improvement in oil market fundamentals suggests that Brent prices are likely to continue to increase to $45/bbl over the next one year. We believe this will likely remain supportive of improving E&P share prices.
… and a good equity hedge to rising inflation: Our economists argue that the aggressive, coordinated expansion of monetary and fiscal policy within the G4 nations, following the recession due to Covid-19, will tend to be reflationary from mid-to-late 2Q20, especially as growth recovers. Aker BP and Lundin’s relatively simpler business models and strong asset quality make them good candidates within the energy sector to hedge against rising inflation, in our view.
However, not all E&Ps provide the same level of risk: At one end, we believe both Aker BP and Lundin Energy have potential to generate strong FCF and have high-quality assets, although there are subtle differences within them in terms of balance sheet strength. Aker BP’s current liquidity headroom of ~$3.7bn compares to Lundin’s $1.3bn, whilst we forecast Aker BP’s net debt/EBITDA to remain below 2.0x even in 2020. At the other end, Tullow and Cairn Energy may require further asset sales to prevent gearing from rising sharply.
We retain our preference for Aker BP – our only Overweight within E&Ps: With sharp cuts to capex and dividend, Aker BP has potential to generate very strong FCF even with Brent at $45/bbl. We forecast average organic FCF of ~$850m during 2021-25, double the current dividend of $425m and implies an average FCF yield of ~14%. In addition, high liquidity headroom gives management the option to pursue any countercyclical and value-accretive acquisition. Finally, the company has a material portfolio of attractive 2C resources, which not only remain underappreciated, but also puts Aker BP in prime position to take advantage of changes to the Norway tax rules, if any. We see more than 25% upside for the shares, alongside a 2020/21e dividend yield of ~7%.
We downgrade Cairn and Hurricane to Equal-weight: We see limited upside for Cairn from current levels, especially considering the risks related to the current liquidity head room and the farm down of its stake in Sangomar. For Hurricane, a series of disappointing news flow related to the Lancaster EPS and the time required to prove the contingent resource base has materially reduced our conviction in our previous Overweight thesis.
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