Read the previous week’s Investment matters.
This week, we move to examine a recent portfolio addition in the Energy sector.
Background
While the portfolio is constantly being reviewed for:
- pricing mismatches in individual stocks;
- the impact of changes in government policy or economic fundamentals; and
- changes in tilts/positioning to recognise long-run fundamental themes…
…the New Financial Year always seems a logical time to consider a reset or repositioning.
Some recent portfolio changes we have made consist of the inclusion of an oil and gas producer. The Energy sector was amongst the worst-performing segments of the ASX in each of the past 2 financial years, and that has aroused the curiosity of the value-minded investor within us.
Source : UBS, ASX
The market
Beach Energy
Beach Energy, is a leading Australian independent oil and gas exploration and production company. While the energy sector is subject to volatility given underlying commodity prices, Beach Energy’s strategic positioning, future cashflow outlook and growth prospects make it an attractive investment within the sector.
- High-quality asset portfolio: Beach Energy boasts a diversified portfolio of oil and gas assets across Australia. The company’s core operations are centred in the Cooper Basin, a proven and prolific hydrocarbon province. This asset base provides a solid foundation for consistent production and cash flow generation. Additionally, Beach has highly prospective assets in the West of Australia (Waitisia and Beharra Springs). Operational efficiency: The company has demonstrated a strong track record of operational excellence, characterized by relatively low production costs and high recovery rates. This efficiency translates into higher profit margins and a competitive advantage in a challenging market environment.
- Exploration upside: Beach Energy maintains a robust exploration program focused on high-impact opportunities. Successful exploration efforts can significantly enhance the company’s reserve base and production profile, driving future growth.
- Significant cashflow strength –
- Improving financial disciplines – with higher return hurdles being implemented, the company is now beginning to manage its exit from its Otway Basin assets.
Industry backdrop – Energy Sector
Australia has enjoyed a golden era as a leading global exporter of Liquified Natural Gas (LNG). However, the industry is now facing a period of significant uncertainty and potential challenges.
The primary concern is the looming oversupply of LNG in the global market. Significant investment in new capacity, particularly by low-cost producing jurisdictions like Qatar, are set to flood the market with cheap gas at a time where global demand may begin to taper. This will put significant pressure on Australian producers, who operate with relatively higher costs. While the immediate future may still be profitable due to existing contracts, the outlook beyond 2028 appears more challenging.
Global LNG Demand and Supply outlook – modest excess supply to emerge
Source : HIS, Waterbourne, UBS
Domestic LNG Demand and Supply outlook – significant excess demand
Source : IHS Waterbourne, EIKON, UBS estimates
But domestically, the outlook for supply is much more modest than demand. Beyond 2030, there is expected to be a 30% shortfall of domestic supply versus demand, which will place pressure upon the Federal Government to allow more exploration licencing to manage the transition towards renewable energy sources while maintaining baseload energy supplies. To this extent, Beach (along with Esso) was recently granted several new exploration permits in the Otway Basin and adjoining Sorrell Basin by the Federal Government.
Company positioning
In mid-June, the company announced the details of its strategic review under a new CEO Brett Woods.
While recognising that the company has prospective assets, management has acknowledged that it needed to have a harder nose towards generating returns from its investments.
A major emphasis was on reducing both operating efficiency as well as reducing capex spending. This was a recognition that Beach remained inefficient, somewhat profligate with shareholders’ funds and needed to earn the right to be given further mandates from share market investors for capital to expand/explore.
M&A Consolidation – Beach – big enough to participate
Given an outlook of growing capacity in the Gas market and possible downward pressure upon global market-set commodity prices, Australian producers are required to find efficiency improvements in order to remain financially viable.
Economic pressures
- Rising costs: The increasing costs of exploration, development, and production, coupled with declining reserves, are making it challenging for smaller players to compete.
- Market volatility: Fluctuating LNG prices and the shift towards spot markets increase financial risks, making larger, more diversified companies better equipped to withstand market downturns.
- Capital intensity: The LNG industry requires significant capital investments. Larger companies have better access to capital markets, enabling them to fund major projects and withstand economic downturns.
Strategic imperative
- Scale advantages: Consolidation can lead to economies of scale, reducing costs and improving operational efficiency.
- Portfolio optimization: By combining assets, companies can create more balanced portfolios with a mix of long-term and short-term contracts, reducing exposure to market volatility.
- Geographical diversification: Mergers can expand a company’s geographic footprint, reducing reliance on a single region and mitigating political and regulatory risks.
Beach is not one of the 2 largest producers in the Australian market. Each of Woodside (No 1, market capitalisation A$52bn) and Santos (No 2, market cap A$26bn) have recently withdrawn from exploring an opportunity to combine to create a global-scale producer.
At a distant No 3 by market capitalisation (~$3.5bn), Beach occupies an interesting position as a potential consolidator in the market. Karoon Energy (market cap $1.5bn) is the only other listed player with a market cap above $1bn. But there are more than 20 other listed Oil and Gas producers listed on the ASX, offering significant scope for industry consolidation.
Beach maintains a strong balance sheet, giving the company flexibility to pursue acquisitions. As its production capacity increases and cashflow generation strengthens further, we believe the company will have considerable firepower for M&A.
Source: Company Data,
As part of the Seven Group Holdings stable of companies (SVW owns 30%), we are confident that Seven’s leadership will insist upon Beach having improved financial disciplines.
We also note that Seven Group has a preference for having operational control of its portfolio assets, which it is yet to consummate. This lends support to our new position in Beach.
Valuation
Most investment bank’s Energy-sector experts see excellent value in Beach Energy at current prices. On a price earnings (P/E) multiple basis, the stock trades around a modest 6x and offers a demonstrably high FCF (free cash flow) yield of 20% in FY-25.
Summary
After a couple of years of share price underperformance but given the stewardship of a new CEO (and other senior executive appointments) who has extensive Oil and Gas production experience, we think that Beach Energy presents as a prospective investment opportunity. We have accordingly added it as a small-sized (~1%) weighting in our Core Investment Strategy.
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.