There has been a clear and noticeable shift in value across our E&P sector coverage this year: stocks have lagged higher commodity prices, driven by increasing focus on ESG, in our view. We estimate the sector is trading 50% below the valuation implied by the current Brent. Further risk measures are extreme with the stocks implying an average WACC of 11%. The sector has underperformed relative to other indices but we believe investors cannot ignore Energy stocks: low equity prices are driving increased M&A and this could be the catalyst to drive the sector towards fair value, in our view.

 Investors highlighting ESG concerns with gas-exposed companies: Investor concerns regarding fossil fuel extraction are not a new phenomenon. However, while in the past much of the focus has been on coal-exposed companies, there has been a noticeable shift towards gas companies. The AFR reported on 19 April 2021 that “natural gas is falling out of favour with emissions-wary investors and utilities at a quicker pace than coal did… Executives at some western European companies say they’re already struggling to sell gas-fired facilities.” While gas has often been called a necessary transition fuel, it is also clear there is an increased focus on climate risk considerations and the potential for assets to become stranded.

 Commodity prices are implying significant upside to fair value: There has been a sizeable shift in value in recent months from the Australian E&P companies under our coverage. On average, since the start of the year E&P stocks under our coverage have not changed in value while the Brent is up 40%. As a measure of risk, we have assessed what the stock prices are implying for cost of capital. As shown below, the implied WACC across our coverage is currently 11.2%, 280bps higher than our base-case. We have also estimated cost abatement already implied in stock prices with carbon costs ranging from US$78/t CO2 (Santos) to US$345/t CO2 (Oil Search).

 We believe investors cannot afford to ignore the E&P sector, with M&A to drive performance: While the implied risk is already substantial, we do not expect ESG headwinds to abate. However, even though the sector has underperformed, investors cannot afford to ignore it: as we have seen in recent months, low equity valuations have started to drive M&A. So far, the bids have been largely scrip-based but we believe cash acquisitions could be the catalyst for sector performance. On that basis, we remain positive on the sector with the majority of stocks we cover remaining Overweight.