Energy Prospectus

Oil & Gas: Going From Strength To Strength

Martijn Rats, CFA – Morgan Stanley
October 12, 2021 11:09 AM GMT

Europe's oil majors are set to generate high levels of FCF, de-gear balance sheets fast, and increase shareholder distributions. With compelling valuations, and rising bond yields driving value rotation, we reiterate our 'Attractive' stance. Shell and Eni most preferred; Equinor to Underweight.

Constructive commodity price outlook: Oil inventories are drawing fast whilst the capex response to higher prices has been negligible. Together, this supports long-term oil prices. Natural gas prices are likely to soften from current exceptional levels but nevertheless stay at elevated levels as supply will likely trail demand.

Strong FCF generation: Marking our commodity price assumptions to current forward curves increases our FCF forecasts across Europe's five oil majors by ~10% to $66bn in aggregate for 2022. At current rates, balance sheet gearing drops by ~5% p.a. on average over 2022/23. Even if Brent were to gradually fall back to $60, Shell, for example, can reduce net debt by ~$45bn and perform a $19bn buyback within three years, on our estimates.

High level of shareholder distribution, with room to move higher still: At the moment, scheduled dividends and buybacks amount to $45bn for 2022, or ~ 2/3rds of the above FCF. With capital discipline now embedded, and balance sheets in solid shape, we expect distributions to continue to move higher.

Buybacks having more impact than expected: In the past, the impact of share repurchases was typically limited at best. At the moment, however, these programs guarantee there is always a buyer, countering the trend of recent years to divest oil & gas shares.

Rising long-dated bond yields drives value rotation: Our strategy colleagues call for long-dated bond yields to rise, which enhances the value of near-term cash flows over far-dated cash flows (note). This is a relative boost for oil & gas stocks, with high near-term distributions.

Valuations still compelling: In aggregate, we estimate European majors trade at a 14% FCF yield, a 4.7% distribution yield, and 3.9x cash flow. These multiples are attractive in a historical context, as well as against international peers.

Shell and Eni most preferred; Equinor to Underweight: Both Shell and Eni have ample 22-23% upside given current valuation metrics and FCF outlook. Equinor is set to benefit disproportionately from the rise in European gas prices. However, this view has become deeply consensual in recent weeks, market positioning is already aligned with this, and valuation multiples are no longer attractive. Also, our commodity call is for European gas prices to weaken in coming weeks.

Morgan Stanley's oil and gas price forecasts

The macro outlook remains constructive for the Energy sector…
The current environment continues to be supportive for long-term oil prices. Many data
points including (1) inventories continuing to draw at high rates,2) improving mobility
statistics across many regions including China,3) improving jet fuel crack spreads,
supporting strong recovery in refining margins, 4) increasing West Africa differentials,
and 5) low global crude loadings, signal oil demand is running ahead of supply. With
negligible capex response to higher prices, so far, we expect oil prices to travel to the
level where demand destruction kicks in. Whilst the price where this happens is difficult
to estimate, we see growing support for our bull case scenario of $85/bbl,near current
oil price levels.

In the Downstream, we witness a sharp improvement in refining margins, supported by a
pick-up in gasoil and jet fuel cracks on higher demand for middle distillates, particularly
jet fuel. Petrochemical margins, which had their peaks in 2Q21, continue to remain at
elevated levels as well.

However, the key surprise in 2H21 so far has been the sharp rally in natural gas prices.
Global gas prices, in recent weeks, have rallied to multi-year highs exceeding $30/mmbtu
in Europe and Asia, setting new seasonal and all-time price records as many gas markets
(similar to many other commodities) tightened faster than we had expected as demand
surged, supply has been constrained, in part due to transitory factors, and storage was
low. Looking ahead, our commodity call is for European gas prices to weaken in coming
weeks, primarily as we expect supply from Russia is likely to increase over the next few
weeks as Gazprom exits its seasonal maintenance and reinjection season (see: Easing the
Squeeze). Nonetheless, despite the softening from exceptionally high levels, we expect
gas prices to remain at elevated levels as supply will likely trail demand.

…leading to strong FCF generation -even higher than our previous forecasts
Marking our commodity price assumptions to current forward curves increases our FCF
forecasts across Europe's five oil majors by ~12% to ~$68bn in aggregate for 2022.
Including the impact of the disposal of the Permian assets for Shell, we forecast
aggregate 2022e FCF at ~$66bn, ~10% higher than our previous forecasts.

More FCF will likely lead to a sharp improvement in the balance sheet strength for the majors.
At current rates, balance sheet gearing drops by ~5% p.a. on average over 2022/23. Even
if Brent were to gradually fall back to $60, Shell, for example, would be reduce net
debt by ~$45bn within three years (during 2Q21-2Q24),even after accounting for a
~$19bn buyback during the period.