I. Sector Landscape and Outlook

Crude oil has been an essential commodity when it comes to the use in modern life, and it has been the world's most significant source of energy. The world relies on it in many ways, not only in terms of the fuel we use for transportation activities and power generation, but it is used in the manufacturing of many essential items. The crude and its derivatives are used as input in many industries such as health and hygiene products, plastics and packaging, clothing, electronics, pharmaceuticals, to name a few.
 

Fig 1: Usage of Crude Oil

 
Source: The Organisation of Petroleum Exporting Countries. (OPEC)

However, the COVID-19 pandemic has been a major unprecedented event that dragged the global demand for crude oil.  Oil prices have been highly volatile since the lockdown was announced by Sino government in the Wuhan city on January 23, 2020. Further, the volatility accentuated sharply post the World Health Organisation (WHO), declared COVID-19 a pandemic on March 11, 2020, and globally countries rolled out a nationwide lockdown, suspended travel activities both domestic and international. Non-essential businesses were asked to close, and people were buying bare essentials to survive amid crisis. Lockdown resulted in an oil supply glut in the market during times when demand for the same was steeply reduced. Crude oil took the brunt of the slump in demand and saw a precipitous drop in prices, the WTI futures momentarily traded deep in the negative.

We believe that the recent production cut announced by OPEC+ cartel and recovery in oil demand on the onset of ease down in lockdown measure will drive crude oil prices in the near term. And it will lead to benefit oil explorers and producers as well. Further, gradually opening of aviation services in China, India, and the United States would also drive recovery in demand for Jet Fuels.

Why Oil Prices Crashed

In April 2020, negative WTI Crude Oil Price episode happened in the wake of anxiety that had gripped traders and investors over news that the oil storage capacity was sharply short at Cushing, Oklahoma, the only delivery point for WTI crude oil. This panic led market participants to rush to dump their future contracts. Also, the April 20, crash in oil price mirrored the extent to which oversupply in oil was prevalent at that time. The COVID-19 pandemic has beaten-down oil prices in a way never seen before.

Fig 2:  WTI 20 April 2020 Intra-day Chart
 

Source: Refinitiv, Thomson Reuters

Dark Clouds Over Crude Oil Abating

Since late April 2020, rush-hour road traffic had shown signs of improvement in the United States, Europe and some Asian and African countries. In China, traffic congestion during peak hours in major cities has returned to normal, and construction work has also resumed, which is aiding the oil refinery processing rates for the nation back to the pre-COVID-19 levels. Also, one of the worst hit European country, Italy has also eased its lockdown, allowing shops, restaurants & bars, and even hairdressers to reopen. The Italian government also signalled to allow flights to and from the country to resume soon. Further, Greece and Portugal also indicated that they might reopen to tourists. Global Aviation is also slowly stabilizing with increased domestic flights in China as quarantine measures eased up. Other countries have also started domestic flights, which will lead to a gradual demand recovery in Jet Fuel as well. Also, ease of lockdown will increase transportation and logistics services, which will also contribute positively to the gasoline demand.

Supply is also supporting recovery in the Oil Prices: Recently, The Organization of the Petroleum Exporting Countries, Russia and other producers, together known as OPEC+, agreed to cut crude oil production output by 9.7m bbl/day from May 01, 2020. According to the agreement, the cuts will begin on May 1, 2020 for two months and then taper before expiring in April 2022, 8m bbl/d through December 2020 and 6 m bbl/d through April 2022. The effective cuts will amount to 7.3 m bbl/d, affecting delivery in June and July. Saudi Arabia and Russia—the group’s largest producers—will together share 57% of the total production cuts, while fast-moving and flexible Iraq, Kuwait and UAE will provide another 20%. In a surprise move, Saudi Arabia further announced cut in production by 1 m bbl/d in June, on top of what the country had previously committed. With this announcement, Saudi’s total production dropped to 7.5 m bbl/d, 40% below April production. Following the leader, The UAE and Kuwait also committed to cut oil production by additional 180,000 bbl/d in total.

This move has also contributed positively to the recovery of oil prices in the international oil market. We believe that a record crude oil production cut and demand recovery for oil and oil derivatives is likely to support crude prices in the near-term.

PPE and Packaging Supporting Petrochemical Demand: Amid challenging times in the oil market, the demand from the petrochemical sector has remained the only bright spot for the crude oil. A fall in oil prices had resulted in the key feedstock Naptha, which is majorly used by the petrochemical industry, to become significantly cheaper. This has flattened the cost curve, curbing the Middle Eastern and North American niche advantage in PPE products and supporting Europe and Asia to increase their operating rates. With higher production rates, petrochemical demand has remained relatively solid in the COVID-19 downturn, with increased demand for packaging, food containers and protective gear.

Oil Price Recovered Sharply from 52W lows:The international crude oil benchmark – Brent Crude Oil and American benchmark West Texas Intermediate Crude (WTI) registered a sharp reversal after April 20 crash. The Brent Crude Oil has recovered approximately 76% from the April 21 bottom level of $19/bbl to $36.20/bbl as on May 26 and the WTI Crude oil which turned negative on April 20 trading session, has also surged significantly and last traded at $34.39 /bbl as on May 26, 2020. The sharp recovery in the oil prices over a month was primarily driven by an improving global demand outlook for the oil and oil derivatives and, we can witness further upside movement in the oil prices once a majority of countries ease out lockdown measures.

Outlook

The demand for crude oil mainly depends on the length of the Covid?19 outbreak and the strength of the subsequent restart of economic activity across the globe. Ease in lock-down and a steady recovery in the global economy in the second half of 2020 could reduce the annual decline in oil demand to 6.5 mb/d. Gasoline demand, in particular, could be supported by an unwillingness to use public transport as recent trends show in China. Also, diesel price could record a sharp recovery than gasoline as a majority of diesel fuel used globally in trucks and ships to transport goods, or in the manufacturing sector, rather than in passenger cars. Also, resumption of industrial and manufacturing activities and loosening of travel restrictions further support the demand. We believe that a reduction in crude throughput by OPEC and its allies and North America also joining the cartel, coupled with an expected recovery in global demand, should drive oil prices and benefit explorer and producer in the remaining months of 2020.
 
II. Investment Theme and Stocks under Discussion (CRN, GENL, SQZ and DGOC)

After understanding the recent trends in the crude oil industry, let’s now look at the four oil explorers those are listed on the London Stock Exchange.To assess the same, companies’ stocks are evaluated based on Discounted Cash Flow (DCF).
 

1. LSE: CNE (CAIRN ENERGY PLC)

(Recommendation: Buy, Potential Upside: Lower Double Digit, Mcap: GBP 706.3 Million)

Cairn Energy PLC (Cairn) is a United Kingdom-based independent oil and gas exploration and development company.



 

 
Valuation

Our illustrative valuation model suggests that the stock has a potential upside of ~17% over the current price of GBX 124 at 1:00 PM GMT on 26 May 2020.


 
 
2. LSE: GENL (GENEL ENERGY PLC)

(Recommendation: Speculative Buy, Potential Upside: Lower Double Digit, Mcap: GBP 320.43 Million)

The company is United Kingdom-headquartered oil and gas exploration and production company. The company's production site is located in the Kurdistan Region of Iraq (KRI).


 
 
 
 
Valuation

Our illustrative valuation model suggests that the stock has a potential upside of ~17% over the current price of GBX 120.6 at 1:00 PM GMT on 26 May 2020.


 
 
 
3. LSE: SQZ (SERICA ENERGY PLC)

(Recommendation: Speculative Buy, Potential Upside: Lower Double Digit, Mcap: GBP 312.9 Million)

Alternative Investment Market-listed Serica Energy plc is an oil and gas company. The company has exploration and development activities based in the United Kingdom, Ireland, Namibia and Morocco, and economic interest in an oilfield offshore in Norway.

 


 
Valuation

Our illustrative valuation model suggests that the stock has a potential upside of ~21% over the current price of GBX 115.8 at 1:00 PM GMT on 26 May 2020.


 
 
 
4. LSE: DGOC (DIVERSIFIED GAS & OIL PLC)

(Recommendation: Hold, Potential Upside: High Single Digit, Mcap: GBP 743.9 Million)

The company is a United Kingdom-headquartered producer of oil and gas. Its operational interest lies in crude oil and natural gas production in the Appalachian Basin of the United States.



 
 
 
Valuation

Our illustrative valuation model suggests that the stock has a potential upside of ~8% over the current price of GBX 106.8 at 1:00 PM GMT on 26 May 2020.

 
 
Assumptions Rationale: We believe the explorers would be witnessing a significant shrink in their FY20 top line as the demand for oil and gas reduced significantly in the first half as most of the economies came to a standstill. However, the governments across the globe started easing the lockdown restrictions starting May, which is likely to help in the demand recovery. A lower income in the first half is likely to take a toll on the companies’ margin. Most of the companies announce the cost control measures and deferred their capital spending.

Risk to our recommendation: Revenue of the oil explorers is directly co-related to the oil price. Any unforeseen event which affects the crude oil price adversely would impact the share price of the oil explorers.

Note: All the recommendations and the calculations are based on the current price at 1:00 PM GMT on 26 May 2020. The financial information has been retrieved from the respective company’s website and Refinitiv (Thomson Reuters).

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