Company Reports

Our AUD 13.25 fair value estimate for no-moat Worley stands. At around AUD 15.45, the sustainability facilitator’s shares are overvalued. Despite our bullish outlook for the company, we think the market is overly optimistic about the value credited, the multiple being paid too high.

Worley is one of the largest global providers of engineering and professional services to the oil, gas, mining, power, and infrastructure industries, with about 59,000 employees and more than AUD 11.0 billion in annual revenue. Strong relationships with global resource and petrochemical firms, along with solid levels of long-term recurring work, provide some element of switching cost support, a competitive strength. While the traditional engineering, procurement and construction management space is competitive, we believe few firms have the skills and capacity to take on the work available in many of the key areas in which Worley operates. Most contracts are of a cost-plus nature, so the risk from project delays and cost overruns is minimized. The highly skilled, specialist nature of WorleyParsons' work means it can earn higher margins than traditional engineering and construction firms.

Worley is one of the largest global providers of engineering and professional services to the oil, gas, mining, power, and infrastructure industries, with about 59,000 employees and more than AUD 11.0 billion in annual revenue. Strong relationships with global resource and petrochemical firms, along with solid levels of long-term recurring work, provide some element of switching cost support, a competitive strength. While the traditional engineering, procurement and construction management space is competitive, we believe few firms have the skills and capacity to take on the work available in many of the key areas in which Worley operates. Most contracts are of a cost-plus nature, so the risk from project delays and cost overruns is minimised. The highly skilled, specialist nature of WorleyParsons' work means it can earn higher margins than traditional engineering and construction firms.

Worley is one of the largest global providers of engineering and professional services to the oil, gas, mining, power, and infrastructure industries, with about 59,000 employees and more than AUD 11.0 billion in annual revenue. Strong relationships with global resource and petrochemical firms, along with solid levels of long-term recurring work, provide some element of switching cost support, a competitive strength. While the traditional engineering, procurement and construction management space is competitive, we believe few firms have the skills and capacity to take on the work available in many of the key areas in which Worley operates. Most contracts are of a cost-plus nature, so the risk from project delays and cost overruns is minimised. The highly skilled, specialist nature of WorleyParsons' work means it can earn higher margins than traditional engineering and construction firms.

Worley is one of the largest global providers of engineering and professional services to the oil, gas, mining, power, and infrastructure industries, with about 59,000 employees and more than AUD 11.0 billion in annual revenue. Strong relationships with global resource and petrochemical firms, along with solid levels of long-term recurring work, provide some element of switching cost support, a competitive strength. While the traditional engineering, procurement and construction management space is competitive, we believe few firms have the skills and capacity to take on the work available in many of the key areas in which Worley operates. Most contracts are of a cost-plus nature, so the risk from project delays and cost overruns is minimised. The highly skilled, specialist nature of WorleyParsons' work means it can earn higher margins than traditional engineering and construction firms.

Worley is one of the largest global providers of engineering and professional services to the oil, gas, mining, power, and infrastructure industries, with about 59,000 employees and more than AUD 11.0 billion in annual revenue. Strong relationships with global resource and petrochemical firms, along with solid levels of long-term recurring work, provide some element of switching cost support, a competitive strength. While the traditional engineering, procurement and construction management space is competitive, we believe few firms have the skills and capacity to take on the work available in many of the key areas in which Worley operates. Most contracts are of a cost-plus nature, so the risk from project delays and cost overruns is minimised. The highly skilled, specialist nature of WorleyParsons' work means it can earn higher margins than traditional engineering and construction firms.

Worley is one of the largest global providers of engineering and professional services to the oil, gas, mining, power, and infrastructure industries, with about 59,000 employees and more than AUD 11.0 billion in annual revenue. Strong relationships with global resource and petrochemical firms, along with solid levels of long-term recurring work, provide some element of switching cost support, a competitive strength. While the traditional engineering, procurement and construction management space is competitive, we believe few firms have the skills and capacity to take on the work available in many of the key areas in which Worley operates. Most contracts are of a cost-plus nature, so the risk from project delays and cost overruns is minimised. Still, Worley has recorded repeat write-downs of onerous contracts. While contracts generally carry lower margins than fixed-price contracts, the highly skilled, specialist nature of WorleyParsons' work means it can earn higher margins than traditional engineering and construction firms.

OPEC's production cuts and strong demand growth have 2017 crude fundamentals in their best shape since oil prices crashed two years ago. The consensus outlook is that fundamentals are now strong enough to remain healthy even after OPEC's cuts lapse. This might have been possible a few months ago, but the odds of this scenario playing out have markedly worsened since. The reason is that major increases in shale activity now have U.S. production firmly on a path of rapid growth, even if rig counts don't increase further. This growth plus the eventual supply increases from OPEC is likely more than enough to erase any market tightness and throw crude markets back into oversupply.

OPEC's announced production cuts this week represent a positive near-term development for world oil markets, removing more than 1 million barrels per day from an oversupplied system. Even after factoring in the inevitable U.S. shale response to higher crude prices, OPEC's cuts point to a meaningful supply deficit next year. Consequently, we are raising our 2017 WTI price to $60 per barrel, up from $50 previously.

For global energy markets, the potential knock-on impacts of a Donald Trump presidency could be meaningful in a few areas. With respect to U.S. oil and gas producers, we can say that the tail risk for regulation of hydraulic fracturing and methane emissions is now somewhat lower. Thus far, the Environmental Protection Agency has maintained that the systemic environmental impact of hydraulic fracturing is benign. A Trump-led EPA is less likely to reverse this view than a Hillary Clinton-led EPA. More tangibly, certain high-environmental-impact upstream segments could benefit from a lighter touch, such as sand mining to supply hydraulic fracturing proppant. Overall, however, state and local governments rather than federal authorities have had the lion’s share of impact on upstream economics.

In a somewhat surprising development, OPEC members have tentatively agreed to a production target of between 32.5 million and 33.3 million barrels per day, representing a reduction of up to 700 mb/d from current production levels of 33.2 mmb/d. Oil prices rallied on the news, but our view for continued low prices of $50/bbl in 2017 (detailed in our Aug. 26 report) remains unchanged, as we do not believe the potential reduction will have a meaningful sustainable impact on oil prices. While the low end of the target range is nearly 1 mmbd lower than our 2017 forecast for OPEC production, and if realized, it would balance markets and reduce inventories sooner than our original expectations, we see numerous risk factors that we think prevent a sustained recovery in prices until 2018.

Crude markets have tightened a good deal in recent months, as strong oil demand growth and supply issues have pulled forward the industry recovery by about a year compared with the outlook we published in April. Even so, 2017 fundamentals are far from robust from an oil price perspective, and don't appear supportive of prices moving much above the $50 per barrel threshold. Another large uptick in rig additions in the U.S. could be enough to eliminate near-term inventory draws altogether, which is the last thing oil markets need for a sustained price recovery to occur. With this in mind, we are setting our 2017 price forecast for West Texas Intermediate at $50 per barrel, which we believe is sufficient to prevent any further net shale activity increases in the coming quarters.

Thanks to ongoing productivity improvements, cost reductions, and slowing decline rates, U.S. shale's cost-competitive growth potential is much greater than the market currently realizes. U.S. tight oil has fundamentally altered the global supply picture, ensuring the industry has more low-cost resources to develop than it will need.

Given the large discrepancy that has emerged between 2017-18 Brent futures prices (currently $40-$47 per barrel) and the Morningstar energy team's outlook for midterm oil industry fundamentals, we are amending our methodology for forecasting near-term oil and gas prices.

The downward pressure on oil prices has continued unabated in the past few weeks, raising the same critical issues for investors trying to find value and understand downside risks amid the current industry crisis. We remain convinced that a handful of compelling opportunities exist for long-term investors. However, we continue to caution that tremendous uncertainty exists as to how oil prices will trend until industry fundamentals improve, which is likely to be a drawn-out process that doesn't begin until the second half of 2016. Accordingly, investors should be discriminating in their stock-picking and prepared to weather additional volatility.

With the U.S. now the de facto swing producer for the global oil industry, a key factor in understanding when oil markets might rebalance is how much U.S. production could ultimately fall from recent record highs.

The most pressing question on the minds of energy investors is hardly a surprise: How long will it take for the industry to work through the current period of oversupply and rebalance itself? The answer, unfortunately, is "not any time soon". Current supply imbalances are such that as of today, oil production is effectively running two years ahead of demand. Declining U.S. oil production during the next several quarters will help reduce global oversupply, but in our opinion that alone cannot quickly fix the current global imbalances.

Although we continue to believe that crude oil prices are well below the levels required to incentivize sufficient investment to meet demand beyond 2017, we are reducing our long-term price outlook by $5 per barrel to $70 Brent and $64 WTI to reflect bearish developments in recent quarters in the outlook for low-cost supply and industrywide cost deflation. While $5 represents a relatively small adjustment to our long-term oil price assumption, we are also adjusting our near-term activity and pricing forecasts to reflect our belief that industry oversupply is making it very likely that crude markets will not approach any semblance of normalcy until 2017. Taken together, these changes have a meaningful impact on a handful of our energy sector fair value estimates, particularly firms that currently employ large amounts of leverage. We are beginning to publish new fair value estimates today, and all companies will be live two weeks from today.

Although we continue to believe that crude oil futures prices are well below the levels required to incentivize sufficient investment to meet demand beyond 2017, recent industry developments point toward our current long-term oil price outlook ($75 Brent and $69 WTI) as being too high. We will launch our new long-term oil price forecast next week, which will be accompanied by updated fair value estimates for our sector coverage.

WorleyParsons reported a 7% fall in fiscal 2013 net profit after tax (NPAT) to AUD 322 million, in line with our forecast and at the low end of the May guidance range. The result reflected weakness in the mining sector, particularly due to a reduction in project spending in Australia, which offset a solid performance by the core hydrocarbons division. We marginally lower our fiscal 2014 and medium-term forecasts to make further allowance for continuation of the challenging mining environment, but still forecast a strong earnings recovery. Our fair value estimate falls from AUD 23 to AUD 22. We retain our positive view of the medium-term outlook, driven by the favourable outlook for capital spending in the oil and gas sector. However, we believe this is already priced in with the shares trading around fair value.