Repsol: Recommend Waiting For More Certainty On Fuel Prices

Investment thesis

Repsol (OTCQX:REPYY) explores for and produces crude oil and natural gas, refines petroleum, and transports petroleum products and liquefied petroleum gas. I have a mixed outlook for, in that I expect things to be uncertain in the near-term, especially after the surprise OPEC cut last month, which will hurt the refining business of Repsol. However, I have a positive long-term outlook given the business transformation over the past years have led to it having a structurally lower cost base, its competitive position in the downstream, and also its renewable portfolio that rides on the long-term secular tailwind for low-carbon transition. Overall, my primary recommendation would be a hold rating until we get more certainty on the oil price situation. However, an alternative recommendation would be to buy invest a small position to take advantage of the attractive FCF yield, while also being nimble enough to be able to size up the position if things go south.

1Q23 results

Adjusted income for Repsol came in at €1.89 billion thanks largely to the success of the Industrial division. Upstream segment adjusted net income of €474 million and Industrials of $1.28 billion both performed better than expected, driving the overall positive result. As for the Commercial & Renewables segment, it reported an adjusted net income of €208m.

Refining segment

My optimistic view of this sector is grounded in the company's history of transformation toward a more efficient cost structure. Importantly, it has reorganized its upstream portfolio over the past few years, selling off assets within the portfolio that are cost-heavy and improving its pipeline of upcoming upstream developments to significantly lower the company's upstream costs. As example would be the recent successes in exploration (in Mexico) that, I believe, will improve Repsol's portfolio and long-term outlook. The strong execution this quarter despite weakening refining margins resulted in a premium over the benchmark margin indicator. As a result, Refining earnings for the company are up 14% from the previous quarter despite a decline in benchmark margin. Importantly, this was accomplished while still operating at a high rate of refinery capacity utilization, a feat that speaks highly of the management's ability to put plans into action. Heavy crude processing benefits, rising biofuels production, and price premiums on the Spanish market all contributed to the improvement over the benchmark. With the wide heavy-to-light crude differentials, I expect the company to maintain its premium over the benchmark in the upcoming quarters. However, margin pressures on higher oil and a narrowing of light vs. heavy crude spreads could result from the OPEC cut, leaving refining vulnerable to weaker demand risks. This cut would not spare Repsol.

Long-term tailwinds

I think the low-carbon transition will be an ongoing topic of discussion, and I anticipate that major players like Repsol will play a crucial role in facilitating this shift to more sustainable energy provision as they have the scale, execution capabilities, balance sheet, and importantly network to drive this change (which smaller players will never be able to compete at the same level). Indeed, after reaching 1.9 GW in 2022, Repsol has continued to grow its renewable portfolio, with ambitious goals of 6 GW by 2025 and 20 GW by 2030. In my opinion, there are two main benefits to easing this transition. To begin with, Repsol will provide a path for it to continue expanding even as competition in the oil and gas industry heats up. The sooner these investments are made, the better off it will be in the new era in terms of competition. Second, by becoming a net-zero CO2 emission company by 2050, Repsol hopes to avoid the stigma from increasingly ESG-wary investors.

Capital allocation

As mentioned, a reason why I would invest in Repsol in the near-term is because of the attractive FCF yield which is dish out to shareholders in the form of dividend and share buybacks. Collectively, I expect high single digit yield, which is based on consensus FY23 DPS of 0.71 (~5.5% yield) and buybacks to fill the balance. As for share buybacks, management stated that a second buyback programme will be declared after 2Q23 results (1Q23 earnings call). That said, the concern I have is the increase in CAPEX for the coming years might lead to management cutting dividends (this is purely my take), and if that happens, the attractiveness of holding the stock will be significantly decreased.

Conclusion

Repsol has had a positive first quarter, with both the Upstream and Industrial divisions performing better than expected. The company's history of transforming towards a more efficient cost structure, as well as its recent successes in exploration, bode well for its future in the refining segment. However, the surprise OPEC cut could result in margin pressures on higher oil and a narrowing of light vs. heavy crude spreads, leaving refining vulnerable to weaker demand risks. Overall, my primary recommendation would be a hold rating until we get more certainty on the oil price situation, but an alternative recommendation would be to invest a small position to take advantage of the attractive FCF yield while being nimble enough to adjust the position if necessary.

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