Brent crude oil is trading at $36 a barrel, down 20%, after OPEC and Russia broke off negotiations on Friday to try and cut the supply by 1.5 million barrels a day. At these levels, it completely breaks through the level indicated by the sector as break even, namely 45-55 dollars. An analysis by Banco Sabadell of the sensitivity of the stocks they cover to variations in crude prices shows that ±1 dollar of crude has an impact of ±2.1% on Repsol’s valuation (-1.9% in adjusted EBIT/ -2.4% in EPS), -2.4% in ENI (-2.1% in adjusted EBIT, -3.4% in EPS) and -2.2% in Total (-1.3% in adjusted EBIT, -2.1% in EPS).
The analysts’ first conclusion is that Repsol, falling by 13%, discounts a perpetual crude oil price of 39 dollars (vs. 45 for ENI and 46 for Total). So it can be said that it is being over-punished, at least in relation to the other stocks.
Despite the “perfect storm” affecting the sector (the lack of agreement on production cuts plus the coronavirus and fears of a recession) Banco Sabadell rules out price scenarios below break even to value the sector. This is because companies would put in place contingency plans that would lead them to stop investing completely and stop producing in the wells with the highest extraction costs. As this would be generalized at a sector level, the price of crude would rebound. And although currently the market will not consider this because the impact is longer term, it is important to keep in mind that the lower the price of crude, the greater the refining margin due to lower energy cost. A rough estimate for a company like Repsol, with its particular EBIT mix (~50% is refining) is that -5 dollars of Brent has an impact of +0.35 dollars on the refining margin. Thus, if -5 dollars of Brent has an impact on Repsol’s valuation of -9.5%, the higher refining margin would contribute +3.3% in valuation. This would reduce the negative impact to a net of -6.2% in valuation vs -10% without netting (-6.8% in EBIT, -8.2% in EPS vs -10% and -12% respectively without netting).
Measuring the impact of a temporary shock is complicated. If the stocks promptly discounted levels of 36 dollars per barrel on their capitalisation, the theoretical falls would be 38% for Repsol, 37% for ENI and 32% for Total. So the drop in share prices today indicate that the market would be giving a 37% probability that these levels would be maintained in the long term (35% for Repsol, 43% for ENI and 34% in Total). Banco Sabadell’s forecast is that crude prices will return to reasonable levels (55-60 dollars) towards the end of the year, while it would be expected that the coronavirus would decrease in terms of the number of short-term infections. An OPEC production cut and/or the imminent announcement of fiscal policies in the US and Europe could lead to a much more intense, short-term rebound in the price of crude.
The most relevant issue is the effect on the companies’ cash flow and dividends, which is outlined below. (The valuation is not being revised due to lack of visibility. That said, the analysts recognize the potentials now seem outdated, maintain their recommendations and see opportunities to BUY in their top picks, Repsol and Total.)
–For Repsol: If the break even before dividends is at average levels of 45/55 dollars for crude, prices of 36/barrel would imply a cash destruction for the company of 540 M euros per year. This would be compensated with less investment (3.800 Bn euros per year). If this shock lasted three months at most, the company would not have to cut dividends given its favourable financial situation (<1x NFD/EBITDA). (Makes a payment of 60% in scrip, although it buys back shares, a yield of 12% at these prices to which can be added a repurchase of 5% of capital).
–For ENI: The price of 36 dollars/barrel (about 19 dollars below its break even) would imply a cash destruction of – 2.850 Bn euros per year (-9% on the capitalization and 25% of the NFD). Given that ENI has a pay out of 107% and NFD/Equity of 0.26x (vs 0.2x-0.25x target), it is the stock where there is more risk of DPS reduction. To cover the dividend, it would have to cut investments by about 36%, which is not reasonable and would force it to divest assets. So it could cut the dividend by about 24% (DPS’19 0.86 euros/acc; 10% yield) in a transitional scenario of Brent at current prices (36 dollars/barrel), provided the average price of 50 dollars/b remains in place.
-For Total (with a break-even of around 48 dollars/barrel) it would imply a cash destruction of -3.960 Bn euros per year (-16% on the annual cash flow, -4% on the capitalization and 12% of NFD). By 2020, the implementation of the divestment programme could result in about 3 billion dollars in cash (c. 50% of the 2020 dividend). Total has a pay-out of 69% and NFD/Equity of 20.7% (vs <20% target), and in a ’20 scenario of the average Brent price at c. 50 dollars/b, we think it would not have to cut the dividend.
