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Impact Investing

IPE special report May 2018

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Oil & Gas: In search of moats

Joseph Mariathasan asks whether investors should take a bullish or a bearish stance on the low oil price 

At a glance

• Falling US supply and the OPEC production cap seem to be setting a floor for the oil price.
• A stable price should bring some capacity back on stream.
• Few see a return to $100 per barrel of oil soon, and pressures to reduce carbon emissions raise questions about future demand.
• Investors should look for stable businesses with strong management that are not excessively leveraged.

Investment prospects for the oil and gas industry are highly dependent on forecasting oil prices which, as even the oil majors such as Shell have found, is not so easy. There have certainly been instances over the past few decades where dramatic price falls to as low as $10 (€8.80) a barrel have caught the industry by surprise. Indeed, the drop from well over $100 in 2014 to under $40 at the start of this year was also an unexpectedly severe drop that has left the industry floundering. 

The problem with oil price forecasts is that politics and not economics can have a greater impact on oil prices. Oil, of course, is a strategic commodity and the US recognises this with its own Strategic Petroleum Reserve, which holds enough oil to supply the country for nearly 40 days. It was started in 1975 after the disruption in supplies, caused by the 1973 OPEC embargo.  

Fracking has clearly been a game changer in both the economics and also the politics of oil. If the US attained oil self-sufficiency over a long time period it would have immense ramifications for US foreign policy towards the Middle East. A big loser would be Saudi Arabia. While US support is clearly still strong, the underlying tensions are obvious. The Saudi Arabian leadership needs US support but faces a balancing act as it struggles with the tensions inherent in its society. Ensuring support means ultimately ensuring US reliance on Saudi oil and to ensure that it needs to drive the fracking community out of business. 

That also has another side benefit where Saudi Arabian interests coincide with those of the US. Russia is heavily dependent on energy exports, which may account for as much as 70% of total exports. Low oil prices in 1990 contributed to President Gorbachev’s struggle to keep the USSR solvent and helped lead to its eventual collapse. 

A low oil price will cause serious repercussions for Russian president, Vladimir Putin, who is also a supporter of Syria’s president, Bashar al-Assad. Indeed, some would argue that ‘weaponising’ the oil price to try to cause political change in Russia has been a key factor in the oil price collapse. Saudi Arabia’s cost of production is still probably not much more than $6 a barrel. US shale oil production costs are probably close to $60-70 a barrel, although some producers may be able to operate at much lower prices, even as low as $20. 

When oil was trading above $100, the US was well on its way to self-sufficiency in oil via fracking. Many would agree with Michael Hintze, CEO of CQS Investment Management, that the decline in oil prices was structural, due to the changes to the market brought about by fracking and the fact that Saudi Arabia was no longer willing or able to act as a swing producer.

The issue for investors is, therefore, should they be bullish on oil prices? Michael Hulme, manager of Carmignac’s Portfolio Commodities fund certainly is. “Share prices have recovered substantially in the last few weeks [as of mid-March]) with many businesses discounting more than $60 oil. This isn’t surprising as falling supply in the US, and a cap to OPEC ex Iran production have begun to set a floor for oil prices,” Hulme says. 

His argument is that the laws of supply and demand should bring things into balance in 2016. “Oil prices should continue to rise over the next 18 months as supply continues to fall while demand remains robust worldwide.” With US exploration and production capital expenditures budgets slashed for 2016, and the rig count continuing to fall, Carmignac believes there will be meaningful production declines from the US shale basins. That should contribute to non-OPEC supply contracting by over 600,000 barrels a day in 2016, or around 0.7% of global supply. 

Outside the US, Hulme say it is difficult to know where the growth in supply could come from. “Saudi and Russian volumes are close to capacity. We believe that the expected increase in exports from Iran, 500,000 barrels a day, is overestimated. The country has, according to our sources, already been exporting a considerable part of its excess production via Iraq.” As a result, Hulme argues, while global demand growth should add 1.2% to demand, overall the supply-demand imbalance could tighten by close to 2% “The world needs more oil every year as its population grows, given the 80m more people per year who will consume it, irrespective of energy efficiency measures.” 

Others argue that the sheer size of fracking reserves will always put a ceiling on prices, even if investment in conventional long tail projects is reduced. “I believe that $40 [plus or minus] $15 per barrel is more likely over the medium term. In the present context and given the current cost curve, my judgement is the $25-55 per barrel range is about right,” according to Hintze.

If Hulme’s thesis is correct, what should investors do? He argues they should prioritise businesses with strong management, a proven ability to generate positive returns through the whole cycle, that are not excessively leveraged and that are, according to Carmignac’s analysis, able to generate attractive and sustainable free cash flow – in other words, rare ‘fortress businesses’ with strong balance sheets. 

These, he suggests, would include oil sands producers, like Suncor Energy, who have stable production and low maintenance capex (unlike shale producers who must spend to keep the oil flowing), as well as shale exploration and production companies with strong balance sheets that can keep their production flat with low capex in a bear market, and will benefit from their capacity to use available resource more effectively. Carmignac’s favoured names in this segment are Anadarko, Occidental Petroleum and Hess. Other examples are the oil services sector via diversified services companies with strong proven management and a technological edge, such as Schlumberger and Halliburton, and oil and gas storage and transportation companies, which benefit from long-term cash flow visibility, such as Enbridge.

Fracking can be brought back on stream quite quickly but the longer the rig count remains low, the harder it is to bring back capacity given the cannibalisation of existing equipment for spare parts, Hulme argues. He also adds that capacity declines outside the US will be harder to reverse. However, Hume does admit that companies are drastically cutting costs and finding new ways to complete wells in the shale sector. “Offshore rig costs are coming down, and standardisation is reducing offshore costs and time to first production. But there’s still a lot of work to do.” 

Yet while drill counts may have dropped in response to the price collapse, price increases will start bringing rigs back on stream as operators hit their break-even levels. That is likely to put a ceiling on oil price increases. Few would expect prices to reach anywhere near $100 a barrel for many years to come, if at all, given the pressures to reduce fossil-fuel consumption. 

Hume does argue that energy transition could also be an opportunity as long-term demand displacement from alternative fuels and renewables will curtail exploration and long-tail projects in oil and gas, impacting supply, and giving oil the potential for a strong bull market in the medium term as long term investment is reduced. 

The other argument in favour of the oil sector is current valuations. “Looking ahead, both the oil services and the integrated oils look really attractive from a valuation perspective, even if there isn’t a particularly strong recovery in the oil price,” says Julian Fosh, UK equities fund manager at Liontrust. 

Liontrust says the UK oil services group, Wood Group, is undervalued on four of five key metrics it uses, with free cash-flow yield of 7.2% versus 3.4% for the UK market. Fosh also believes that Shell and BP have sunk to valuation levels that more than discount the current situation. “For them, cash flow is more of an issue, although both have pledged to maintain their dividends and appear to have the financial flexibility to do so.” As a result, Fosh is optimistic for the sector. “We would expect to see the shares we hold start to re-rate even without a strong recovery in the oil price. If there is such a recovery, they should see [earnings] upgrades as well, so there might be a double whammy,” he says.

Investors might wish to consider whether high yield debt could provide a better risk/reward play than equities for the oil and gas sector. If oil prices are still $40 per barrel or less in a year, some producers will default. Those producers that can still find equity will increase their share and low-cost producers will fill the gap.

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