Inflation to drive up marginal costs and break-evens
• Revisiting the impact of higher inflation – a theme prominently highlighted since early 2021
• Cost inflation more apparent in US shale and Renewable Energy
• Geopolitical tensions resulting in volatile commodity prices but remain positive on sector over longer term
Inflation is not a new word to us. As early as the beginning of last year, we had been highlighting the Energy sector as one of the key beneficiaries of higher inflation in our sector reports. We have also featured Energy stocks prominently in various Equity Strategy reports positioning for re-opening and higher inflation as early as 1Q21, and have also maintained an Overweight rating on the Energy sector since our upgrade in 3Q20. Looking ahead, while commodity prices may remain volatile and the sector may be vulnerable to a pull-back in oil and gas prices should geopolitical tensions ease (Russia/Ukraine tensions) and an Iran nuclear deal is reached, commodity prices are still not low by historical standards and are supportive for the industry.
Should exploration and production (E&P) capex levels remain unchanged in an inflationary environment going forward, this could create a risk to volume guidance as higher inflation will also pressure companies’ break-evens. We get the sense that cost inflation is being experienced fastest in US shale operations and in Renewable Energy generation amongst the Integrateds, based on managements’ comments during the reporting season. The US majors sounded less concerned with inflation, stating that potential increases should be offset with efficiencies/cost reduction targets, while comments from Oilfield Services companies were more varied.
Economies of scale count in inflationary environments, putting the Integrateds in good stead – at current levels only TotalEnergies, PetroChina and Sinopec are those with upside potential. Within the E&P space, Woodside Petroleum, Santos and Coterra are rated BUY, while CNOOC is HOLD-rated with upside. US refiners are mostly fairly valued, while Schlumberger and NOV still have upside within the Oilfield Services space. However, do note that these are relatively more volatile stocks and may not be suitable for more risk-averse investors. As for the Midstream companies, Enbridge and Enterprise Products Partners still have some upside. (Research Team)