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David Stevenson: are energy stocks the new tobacco?

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David Stevenson: are energy stocks the new tobacco?

It’s not been a great few years to be running a fund that invests in the global energy industry. To be fair to this select band of hardy veterans, there is every reason why a fund that invests in the fossil fuel industry makes sense, especially if you look at the world via the lens of classifications and sectors.

Technology  stocks and financials may comprise around 15% each of the world’s total stock market capitalisation (and there are plenty of funds focused on both of these) but energy businesses still command 6% of the total global value of stocks, and that number is much diminished after a nasty few years of price declines.

The names featured in most portfolio lists of these fund managers is also mightily familiar to UK private investors – huge brands such as BP (BP) and Shell (RDSb). And as we’ll discover the large integrated energy businesses are also turning into formidable cash machines. Yet despite all these tailwinds, investor interest in energy funds is probably close to all-time lows.

There are, in truth, a myriad of reasons for this apathy. Lurking in the background is I suspect an innate fear of volatility. You may be investing in well run, large cap stocks but their share prices are vulnerable to the ups and downs of the oil price – and boy are those prices volatile.

I’ve long tracked the oil price and its relationship with gold prices (once strong, now less so) and US equities (usually much weaker but strong in recent months) but even I have largely given up guessing where prices might head next.

Talk to fund managers at Westbeck (who run a small long short energy fund) for instance and they’ll tell you that the Brent curve (over first 12 months) has moved from $2 in 'contango' to $2 in 'backwardation'. This, they say, is 'signalling a market that is now significantly undersupplied versus seasonality. OECD monthly inventory data and "real-time" US weekly Department of Energy crude oil inventories both point to a market that is 600 to 700 kilo barrels per day under-supplied'.

In sum Westbeck expects inventories to draw further into the summer, 'and the continued strong performance of the Brent timespreads, suggesting an undersupplied and tightening global market, confirms that view'.

Managers at Guinness are also cautiously optimistic, with prices looking like they are stabilising around $50 to $60 a barrel (the average is $53.2 for West Texas Intermediate (WTI) in 2019) which is slap bang in the middle of the range of what I suspect is the market consensus at the moment i.e $50 to $70 a barrel. WTI prices averaged $64.9 a barrel in 2018, $51 in 2017, $43 in 2016, $49 in 2015 and $93 in 2014.

But the numbers in the table below – which shows the main energy funds plus Westbeck and statistics for the accompanying index – reminds us that guessing what might happen next for the oil price is essentially a mug's game.

Most of the funds have had a good start to the year but big losses were notched up in 2017 and 2018 as oil prices crashed after the amazing bull run of 2016. My own guess is that 2019 might prove to be a slightly better year but I’d wager that my odds at guessing this outcome over the full year are about as good as guessing who might win the next Grand National.

Fund 2019 (%) 2018 (%) 2017 (%) 2016 (%) Yield (%) Top three holdings
Investec Global Energy 10 -12.1 -13 50 2.4 Total 9%, BP 9%, Shell 6.8%
Artemis Global Energy 11.6 -6.3 -7.2 65.2 1.2 Total 4.7%, Chevron 4.5%, BP 4.4%
Guinness Global Energy 9.2 -14.7 -9.9 52 n/a Suncor Energy 4.1%, Canadian Natural Resources 4%, OMV 4%
Westbeck Energy Opportunity (*launched June 2016) 21.6 -27.4 -17 22.1* n/a Parex Resources 6.7%, MEG Energy 6.4%, Hess Corp 3.1%
MSCI World Energy Sector Index ($) 12.5 -18.2 2.1 6.3 3.7 Exxon Mobil 14%, Shell 11%, Chevron 9.8%

But I don’t think we can pin the negativity towards the sector completely on those violent price swings. There’s also a deep sense that the underlying energy market is out of kilter.

Two factors stand out. The first is that Opec is trying to reimpose control, working alongside the Russians. The oil producer’s cartel and especially the Saudis seem to be steadfast in their determination to adhere to the discipline of their agreed programme of cuts and compliance is forecast to be above 100% in March according to Westbeck.

Unfortunately this tailwind runs into an increasingly obvious headwind – the US and its shale revolution, focused on the giant Permian basin. The last readily available numbers indicate that US onshore production increased by 69 kilo barrels per day during December 2018. This means that year-on-year growth for the US onshore system is currently running at around 1.6 million barrels per day for 2018. In sum the US has become a huge oil exporter again and its only likely to get worse.

The oil giant Exxon Mobil (XOM.N) is getting behind US shale and is now targeting a million barrels per day by 2024. At this point I feel its incumbent to remind readers that the rise of US oil dominance (again) is not assured, especially if the US capital markets rebel and stop providing cheap finance for the sector, which prompts industry observers to look at US oil rig counts.

These do suggest a slowdown of sorts with the US onshore drilling rig count falling by 42 rigs (5%) in the first nine weeks of 2019, increasing expectations of a slowdown in US shale oil production growth later in 2019, according to Guinness. But personally, I think all this talk of peak shale is a day dream. The US is going to pile ever larger sums of money into its energy sector, open up countless new oil and gas pipelines and refineries and is going all-out for energy dominance. That’ll keep a lid on oil prices for much of the next few years.

If these worries weren’t enough, investors also fret about the oil sector’s vulnerability to the global economic cycle. Put simply, oil and energy stocks become a risk-on bet. Again, I have no idea what might happen to the global economy but my wager would be on the current slowdown ending in the next few months and for growth to pick up steam again later in the year. But again, that’s only a guess and I’d put those odds no higher than my winning Grand National bet.

And then there’s the elephant in the room – the fossil fuel free movement. There’s been a steady move to dump energy stocks from portfolios of big institutions – only recently for instance the Norwegian sovereign wealth fund announced that it was starting to sell off its energy stocks. This embargo movement is building momentum and I think its entirely possible that within a few years a sizeable segment of the institutional fund market will refuse to invest in energy stocks – echoing the tobacco divestment movement from recent years.

One last sentiment might also be lurking in the background – a worry that I believe could eventually turn into a big positive for the sector.

Put simply, most big integrated oil businesses have turned into everyone’s favourite, unloved, value stocks. Whereas until recently most banks and financials were glaringly cheap, now energy stocks have taken that crown. Price-earnings ratios are low, and dividend yields are rising (see my article from last week for my worries on this score).

At the moment the main concern of most investors is parochial and short term, that as soon as profits increase in the sector, the majors go bonkers on capital expenditure. Massive new production plans are announced and the world is flooded with cheap oil, again, the classic resource stock trap.

The industry did largely react to the price crash as you’d expect – killing expansion plans and capping spending. But as the chart below from Guinness shows, that spending drought is slowly turning and the big oil majors are starting to spend lots and lots of money again. But the rebound this time is much less pronounced and most of the extra cashflow is going on reducing debt and increasing dividend payments.

Source: Evaluate Energy, Bloomberg, Guinness Asset Management

This message comes through loud and clear in the second chart from Guinness below – it shows that free cash flow yields are spiking and that we’re now back to peak inflows. As long as most of that money doesn’t get spent on new hydrocarbon platforms, the future might be brighter for the sector.

Source: Bloomberg, Guinness Asset Management estimates

The upside was I think very eloquently put by John Dodd from Artemis, an experienced manager in this space, late last year. 'Companies like BP and Total are starting to make themselves "cycle proof". This goes beyond cutting costs – they are changing the way they operate by standardizing, optimising and digitising. This means the sector could generate respectable (10%) returns on capital even were long-term oil prices to be below $50 per barrel.

'So with oil prices averaging around $65 per barrel in the period, excess cash is being used to cancel debt, buy back shares and pay higher dividends. But this still isn’t doing the trick – the sector is still under-owned, even though the fundamentals have never looked better.'

In sum we have the makings of a classic value makeover, rather like the one that happened in the tobacco sector. Investors fell out of love with the sector, worried by huge litigation costs and an active investor divestment movement. Share prices fell but the corporates react intelligently – they focused on cash flow and margins, spending money on growth markets in the emerging markets and then handing that money back to investors through dividend cheques. Eventually these 'sin stocks' found favour again and their share prices bounded back.

My own slightly alternative take is to ask where the investment in the future might go. Exxon Mobil is betting on classic hydrocarbon projects that play to its core engineering strengths. It's ignoring all those fossil fuel free investors (who currently amount to a tiny portion of the total institutional market) and betting everything on growth in oil.

But rivals such as Shell realise that investment in the integrated energy and power sector is necessary and that means thinking about how to play the renewables push in a profitable way. There is of course a risk that these oil majors will be hopelessly out of their depth in this new carbon free world but there’s an equally good chance that outfits such as Shell and BP could make the transition. So, careful, judicious investment in natural gas and the renewables sector, plus generous cash cheques, to investors could reignite interest in the sector.

Two wild cards stand out for the sector. The first is that from January 2020, the limit for sulphur in fuel oil used by ships operating outside designated emission control areas will be lowered significantly. According to Dodd at Artemis 'this means the world’s shipping fleet will need to run on diesel, creating a massive new source of demand for middle distillates. This will favour oil companies like Repsol that can provide these grades of fuel. We are already positioning into these refiners to benefit from this change.'

And then there’s geopolitics. Currently the key challenge is  posed by our socialist friends in Latin America, Venezuela. According to Guinness energy production in the country is 'problematic with estimates that production for March will fall further, reaching 0.8 million barrels per day, having been around 1.2 million in late 2018. The US envoy to Venezuela was recently quoted as suggesting that production will fall to 0.5 million'. Add in various issues that may arise with those other fantastically friendly guys in Iran and we have the running possibility that oil prices could spike in the not too distant future.

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