Buy Hold Sell

Buy Hold Sell: Why energy stocks are cheaper than they've been in years (and 2 stocks on the rise)

Mon 03 Jul 23, 10:54am (AEST)
BUY HOLD SELL PrimaryYoutube (2)

Key Points

  • Good reasons for optimism on old-world energy sector, say James Gerrish and Joe Wright
  • Are energy stocks cheap or expensive at current levels?
  • Two resources stock pics for the year ahead

In a high-inflation environment, energy stocks typically perform well due to the ongoing need for its core product. It’s no surprise, therefore, that the energy sector began a strong rally in 2021 when inflation took off.

That rally extended into early 2022, when the Ukraine war was added to the equation and energy security concerns kicked prices and shares even higher.

But as inflation and war morphed into higher interest rates and concerns about global growth, oil and coal prices have come off sharply in the past 12 months. And all of this is to say nothing of the large-scale energy transition that is taking place, which is tipping the sector on its head.

So, what is one to make of all of this and, more importantly, where are the risks and opportunities?

To answer those questions, James Gerrish from Market Matters and Joe Wright from Airlie Funds Management joined Livewire’s energy sector special of Buy Hold Sell.

Note: This episode was filmed on Wednesday 28 June 2023 and first published for Livewire Markets on Monday 3 July. You can watch the video or read an edited transcript below.

Edited Transcript

Chris Conway: Hello and welcome to Livewires Buy Hold Sell. My name is Chris Conway. After a strong 2021 and early 2022, coal and oil prices have taken a big hit in the last 12 months. So what can we expect from here and are energy companies attractive opportunities for long-term investors, right now? To answer that question, I'm joined by James Gerrish from Market Matters and Joe Wright from Airlie Funds Management. Let's start with the big picture. Energy security has been all the rage since the onset of the Ukraine War. What's the outlook from here? James, let's start with you.

Energy sector outlook

James Gerrish: I think the big things that we're talking about at the moment are decarbonisation and electrification, pretty much of everything, but obviously that doesn't feature too much in the old-world thematics that we're discussing today. But it comes down to the outlook around supply and demand.

I'm positive on the energy space, the old world energy space, in the short term because of the supply side issues that are playing out. Less supply meeting growing demand should see prices higher. Obviously, the next 10 years are probably going to be a little bit different. I'm talking about the next couple of years, I think the outlook looks positive and we're positioning portfolios accordingly, Chris.

Chris Conway: Joe, what's your outlook from here?

Joe Wright: Yeah, we agree with James. I think the fundamentals for old-world energy commodities still look pretty good in the short term, and prices are still at a point where companies in the right part of the cost curve will earn good returns.

In terms of renewable energy, like any energy producer, it'll just depend on their cost of production and we see a good opportunity for old-world energy companies to invest in renewable energy solutions where the returns are right.

Old-world versus new-world

Chris Conway: Joe, what does that mean for both old-world energy and new-world energy companies alike?

Joe Wright: Like I was saying before, it's just going to come down to where your assets are positioned on the cost curve. If you've got a low-cost producing coal company, you're probably going to last through any sort of down cycle and come out the other side. If you're high on the cost curve, you won't do so well. Similarly, in renewables, the advantage renewables have is that commodity prices may get adjusted for a price of carbon, which would put them in a favourable position versus other old-world commodities.

Chris Conway: James, same question. What about you?

James Gerrish: I think the more interesting thing at the moment is how old-world energy companies are transitioning to the new world. So AGL Energy (ASX: AGL) is probably a great example of that recently. They're the biggest carbon emitter in Australia. They're moving away from coal power generation into renewables.

We've seen the share price rise as the market transitions from being concerned about that, to seeing what the scope is for them to use the cash flow that's being generated in the old world to fund the new world energy solutions. We've seen a rerate in the share price.

You think about BHP Group (BHP), it’s probably a longer shot example around how they're transitioning out of petroleum oil, et cetera. In 2015 and 2016, 40% of their earnings were coming from that part of the business. Fast forward two years’ time, 40% of earnings are going to come from copper, which is underpinning that decarbonisation thematic.

So to me, it's all about how companies are transitioning and that's why old-world energy producers have got the cash flow to fund the move into new-world energy, if you like.

Are energy stocks cheap or expensive?

Chris Conway: James, I'll stay with you. How expensive are energy stocks right now compared to history?

James Gerrish: They're cheap if energy prices rise. Our view is energy prices will rise. So the energy producers are cheap on historical metrics. If you look across the suite of energy companies in Australia, they're probably one standard deviation on normal valuation metrics. Cheap. But it comes down to what energy prices do. The one thing I've learned over the years is if you get the commodity price correct, you generally get the stock price right. So if energy does what we expect it to do in the next two to three years, then these stocks will prove to be cheap and now will be a really good buying opportunity in some of those old-world energy stocks.

Chris Conway: Joe, what about you, expensive or cheap for energy stocks right now?

Joe Wright: We think plenty are cheap. If you look at PEs in this upcycle for energy prices versus previous cycles, they're much lower. And sure some of that derate is because the demand profile for these commodities have changed, but we don't think they've changed to the extent that the companies have derated. Many of these companies have the strongest balance sheets they've ever had in their listed history.

What about the dividends?

Chris Conway: Joe, staying with you. Many of the stocks in the sector have very high trailing yields.

Can they be sustained as we move forward?

Joe Wright: That's just going to come down to a view on future commodity prices. We're probably more constructive on the fundamental supply-demand dynamics of oil and gas, maybe over thermal coal, and so probably those yields are more sustainable than some of the high-cost thermal coal companies.

Chris Conway: James, what about you? Yields, can they be maintained as we move forward?

Joe Wright: It’s all a form of capital management, right? So you think of in the coal space, New Hope's (ASX: NHCpaying a lot of their earnings out as dividends, Whitehaven (ASX: WHC) is buying back stock. So it comes down to capital management. If commodity prices, as I said before, rise from here, then those dividends will be sustainable.

But at the end of the day, it's a function of earnings, of commodity prices, of pass-through of the cash flow that's generated from the commodities that they're selling. It's very different to a more stable sort of dividend stream that other stocks can deliver. So have that in the back of your mind if you're buying commodity stocks and energy companies solely for the dividend.

New Hope Corporation (ASX: NHC)

Chris Conway: Let's get into buy, hold, sell. The first stock that we're going to talk about is New Hope Corporation. Of course, the coal miner share price has slipped 16% since the start of the year. Are you buying the dip, James? Is it a buy, hold or sell?

James Gerrish (BUY): We own New Hope. So it's a buy here. It's slightly below where we bought it, but you've got to consider that they paid out 40 cents in fully franked dividends in April. So that's obviously supportive of the total return that it's generated. It comes down to coal prices and I think coal prices are a low point. New Hope's probably at a low point. So it's a buy for income-focused investors in my book, Chris.

Chris Conway: Joe, what about you, buy, hold or sell?

Joe Wright (HOLD): We don't own it, but if we did, it would be a hold. I think the balance sheet's in great shape. It's obviously on a really low multiple. They've got a good asset in the right part of the cost curve. For us, again, we're just not as constructive on thermal coal as some other energy commodities, and that's why it's probably a hold and not a buy.

Beach Energy (ASX: BPT)

Chris Conway: Next we have South Australian Energy Company, Beach Energy. Joe, stay with you. Is it a buy, hold or sell?

Joe Wright (BUY): We have exposure to Beach through Seven Group (XXX), which owns 30% of the business and we think it's a good buy here. I think the company probably missed expectations, 15 out of 16 quarterlies. But looking forward, we think East Coast and West Coast gas markets stay tight. We think production is going to lift materially as some of these new projects come online and the stocks sub three times EBITDA.

Chris Conway: James, the stock is also down 16% since the beginning of the year for you is it a buy, hold or sell?

James Gerrish (HOLD): It's a hold only because I'm constructive on the energy landscape from here. So operationally they've been really poor. Their assets are pretty challenging and that's led to those few operational missteps that Joe has just highlighted in their last 15 quarterlies. So if I look at the landscape for energy companies, Beach is not the one I'm out there putting all my money into right now because of those operational challenges.

Paladin Energy (ASX: PDN)

Chris Conway: Next up, we're going to talk uranium and in particular, Paladin Energy. Lots of people are talking about it at the moment. James, I know it's been an area of interest for you. Is it a buy, hold or sell for Paladin?

James Gerrish (BUY): I think Paladin is a buy. I'm constructive on the whole uranium space here in Australia. We've got some really interesting uranium companies that are either near production or, like Paladin, are coming into production, so they should be producing from their Langer Heinrich mine in Namibia, which is being brought back on stream as we speak. So Q1 of calendar '24, the price environment for uranium looks really strong. So the term contract market has really picked up in the last six months. All these nuclear-powered countries, or countries that are embracing nuclear energy, are building more capacity. We think there's only upside for the uranium price and I'm bullish on it. We own Paladin and would be a buy here around 70 cents.

Chris Conway: Joe, the share price is up 5% year to date, buy hold or sell for you?

Joe Wright (HOLD): It's a hold for us. I totally agree around the sort of changing fundamentals of the uranium market. I think it's increasingly looking very positive. For us though Paladin's a company with a single asset. It's in Namibia, it's ramping up. We want to see where it settles on the cost curve before we get more constructive. So that would be a hold for us, not a buy.

Chris Conway: We asked the gents to bring along their best stock for the coming 12 months in the energy space. Joe, we'll stick with you. What is your pick for the next 12 months?

Santos (ASX: STO)

Joe Wright: Yep. Hardly a diamond in the rough. We've got Santos at a buy. Oil and gas major. Long-life quality assets in the right part of the cost curve. Some of the sentiment around the stock has been pretty negative the past 12 months. We've talked regulatory delays, project sell-downs not coming through. We think those are subsiding, turning into positive catalysts.

And then when we look across the entire energy space, it's rare that you've got cashflow now, more cashflow coming as production grows, assuming commodity prices stay where they are. And probably the best decarbonization plan of any old-world energy company on the ASX as they ramp up CCS projects and decarb their existing assets.

Chris Conway: And James, what about you? Your highest conviction energy stock for the next 12 months?

Worley (ASX: WOR)

James Gerrish: Chris, mine's a little bit different. So it's about a company that will benefit from moving from old-world energy into new-world energy. So Worley is our high-conviction buy. You look at Worley of the past, they've never had issues winning work. They've had issues making good money out of the work they win.

If you look at their book now, they've got 40% of their book in projects associated with decarbonisation, high margin work. The market's growing and they're winning market share. So we think that's going to drive earnings over the next 12-24 months and beyond. 

Chris Conway: That's all we have time for today. We hope you enjoyed that energy sector special of Buy Hold Sell. If you liked it as much as I did, make sure to give it a like, and don't forget to follow our YouTube channel because we're adding lots of great content every single week.

Written By

Buy Hold Sell

Buy Hold Sell is a regular video series where Australia's leading professional investors share their views on Australian and Global Shares. This content is produced by Livewire Markets and has been syndicated to the Market Index website.

Get the latest news and insights direct to your inbox

Subscribe free