Yesterday, when Saudi Arabia revealed its "draconian" 2016 budget [10], boosting gasoline prices by 40%, while trimming welfare programs after forecasting a collapse in oil revenue (even while allocating the biggest part of government spending in next year’s budget to defense and security) Bloomberg reported [11]that "the kingdom’s 2016 budget is probably based on crude prices of about $29 a barrel, according Riyadh-based Jadwa Investment Co."
Shortly thereafter Iran's Petroleum Minister Bijan Zangeneh said that the Iran 2016-2017 budget assumes an average oil price of $40 dollars per barrel. "There have been efforts to suggest in the budget the closest and most possible price for oil, though the market is usually in fluctuations," Zangeneh was quoted as saying by the local IRNA news agency.
The reality is that nobody knows where oil prices will be in the coming year, especially if the supply glut persists, something which prompted BMO to warn [12]that unless there are dramatic changes in the supply picture, oil prices could collapse as low as $20 in the short-term. "Fundamentally there is simply too much oil" the Canadian bank summarized simply.
But now that price expectations have been significantly reset lower to account for an OPEC which will likely continue to exceed its 30 million barrel per day target, one group's implied oil price estimate stands out: that of energy investors.
Here is what BMO says is the oil price discount into current equity valuation.
At current prices we estimate that valuations for the oil and gas group reflect an implied Brent crude oil price in the range of $65-70/bbl while natural gas leveraged companies reflect a Henry Hub natural gas price in the range of $3.00/Mcf.
We have shown before that this is a problem for energy stock valuations which, while not as extreme as they have been in recent months, still discount energy earnings doubling over the near term with a 26x forward P/E, nearly double the recent historical average.
[13]
As the company-level chart further shows, not a single company's valuation is "fair" at current oil prices. In fact, should oil persists below $40, every single company in BMO's universe is overvalued.
[14]
In discussing the future of energy company valuations, BMO adds that "while these generally represent attractive levels compared to our longer-term commodity price expectations we see a higher likelihood of weaker crude oil prices over the next six months which would take valuations lower."
So why are energy multiples so persistently high? The answer is simple: equity investors are basing their investment thesis on the oil price corrections of 1998-1999 and 2008-2009, when likewise, multiples spiked only to retrace, following a rise in oil prices. BMO next explains how current equity valuations compare to prior downturns:
Based on the oil price corrections in 1998-99 and 2008-09, it appears that consensus estimates and valuation multiples have not fully adjusted, which suggests valuations could be overstated. Chart 37 illustrates the tight relationship between consensus earnings estimates and oil prices over the 1994-2000 period. As you would expect, consensus earnings multiples adjusted to compensate for sharp changes in oil prices, expanding during falling oil prices and shrinking during rising oil prices.
[15]
Consensus earnings and P/E multiples largely followed a similar pattern over the 2005-2011 period and oil price correction in 2008-09.
[16]
The bank's conclusion: "as shown in Chart 41, consensus earnings are being rapidly adjusted for the sharp reduction in current oil prices and future expectations while valuation multiples have expanded. To us this suggests that there is downside to group valuations."
[17]
What the above - and recent analyses [12]on the topic - suggests is that, paradoxically, the best outcome for energy equity investors is for there to be a sharp, sudden spike lower in oil prices, one which would result in a shock to the system, and quickly take out the most inefficient corporate and sovereign operators, in the process removing much of the dreaded supply overhang.
Alternatively, the worst case is the continued slow burn in oil prices lower, which will achieve the same outcome however over a far more stretched-out time frame, while punishing even the best run oil producers whose liquidity (or FX) reserves will be vastly more depleted by the time the mass defaults take place. Over that time, both earnings and multiples will collapse and the result will be a far more extended energy price bear market, together with the now daily sharp "this time it's the bottom" short squeezes.
And the biggest irony, the longer stock prices remain elevated, the longer even the more troubled companies can stay solvent by selling first bonds, then when that market shuts down, selling equity to other naive investors, perpetuating the cash bleed until finally in a Lehman-like event, there is a dramatic repricing of all asset classes. The only difference is that when Lehamn filed, it was the bonds that went from nearly par to 8 cents overnight. With energy companies it will be the equity tranche that has an identical repricing.
