Oil investors look for one last super-cycle
As the pandemic starts to ease, fund managers focused on the oil and gas sector predict a price recovery but still value the protection of strong balance sheets
Amid the doom and gloom of lower prices and the energy transition, investment funds that focus entirely on oil and gas are looking beyond what may be a negative overreaction in stock prices. While the sector has certainly undergone a difficult period, severely lower stock prices may offer opportunities.
Working against them, the stock ‘universe’ for funds that focus on oil and gas has contracted in recent years. This is reflected in the total assets managed by global energy sector equity funds—those that invest in coal exploration, oil and gas, pipelines, natural gas services and refineries—which have almost halved since 2017, to $64.4bn, according to research platform Morningstar Direct’s data on all open-ended and exchange-traded funds.
The clients that have retained faith have scarcely had an easier ride. Funds with heavy exposure to oil and gas companies have suffered some of the worst performances of any investments this year— unsurprisingly after the oil price dropped to historic lows. The S&P Global Oil Index, which tracks 120 of the largest public oil and gas companies, had fallen by 36.79pc this year as of 22 May. However, it has recovered some losses since falling to a historic low, with the index up 16.74pc since 1 April, while the US market is doing even better with the Dow Jones US Oil and Gas Index up 30.44pc over the same time period.
In such volatile times, oil and gas fund managers understandably say they prefer to invest in companies with robust balance sheets. When there is a recession—or a pandemic such as Covid-19—falls in commodity prices drive down cashflows and endanger the ability of companies to repay debt and, ultimately, the existence of those companies.
“The [stock] market’s willingness to take on risk seemed too high and valuations did not compensate for the risk of an unknowable future,” says equity value investment specialist Andrew Williams of UK-based fund manager Schroders.
“The earnings and cashflows of energy companies are highly sensitive to the broad economic environment,” he adds. “As value investors looking for income, we favour strong balance sheets, and many companies will have the financial capacity to maintain absolute dividends through a temporary profit dip.”
His colleague, value fund manager Kevin Murphy, adds: “The oil majors are less sensitive to the price of oil than one might expect because they are vertically integrated. Other parts of the energy sector look more vulnerable. If the low oil prices persists, then highly indebted E&P companies look particularly likely to see significant liquidity and balance sheet stress.”
He is not alone in focusing on balance sheet strength. Kevin Holt, chief investment officer for US value equities at $1.05tn investment giant Invesco, is concerned the industry has had too much leverage.
“As long as capital continues to be rationed within the industry, larger companies will continue to sell assets” Cheng, Kerogen
High dividends are in principle very attractive for investors, but the wisdom of paying them has come under pressure since the oil price fall. Shell alarmed investors in May by cutting its dividend by two-thirds, and many other majors are expected to follow suit.
“We normally get around 8pc returns from non-oil and gas stocks in our portfolio. But since 2008 we have only had around 3pc from the oil and gas majors,” says Holt. “This is why dividends from the integrated companies are so important. And, for an industry that has invested too much money, dividends prevent them from just reinvesting money in whatever they want.”
If demand for oil is to inevitably decline during the transition to a lower carbon economy, fund managers can reasonably insist that oil and gas companies accept that they are maturing businesses and pare back ambitions for hydrocarbon-based growth. But this need not sound the death knell for increasing value.
“They are cyclical companies but if they behave properly, understand that they are not growth businesses and run themselves accordingly, investors can still make money. When companies get to a cyclical average or slightly higher, investors could sell them.”
Holt hails US energy firm ConocoPhillips as having the "perfect business model" because it pays the management team on cashflow-per-share. Ditching a growth-focused business model has paid off; in the last five years, it has been one of the sector’s best performing stocks. “ConocoPhillips fully admits over time that it will shrink. Companies need to embrace this model as opposed to trying to find more oil resource,” he adds.
Holt is also concerned that oil and gas majors may over-invest in alternative energy when it is not their core competency. He advises they move into alternatives “smartly” to avoid destroying business returns even more.
“Some companies are handling that better than others,” he adds. “Even better are the companies that do not necessarily go out and make investments into renewable energy, but maybe they will use that technology as part of their electricity to run the oilfield, for example. [It is better to] help the environment in that way rather than trying to be the next solar company, which is probably a little aggressive.”
Private equity companies have been a significant contributor of capital to oil and gas E&P firms over the cycles of the last decade. According to alternative assets data firm Preqin, $381.5bn of private capital was raised between 2010 and May 2020, reaching peak levels between 2013 and 2016, but it has been dwindling since.
Approximately 90pc of this capital dedicated to oil and gas has been focused on North America, according to Preqin. But some private equity managers, such as Kerogen Capital, focus on the sector outside the US. The firm does not have to invest exclusively in oil and gas, and tends to focus on relatively lower carbon assets by shunning projects such as tar sands and coal. It is looking for opportunities that might become available over the next 12 months following the fall in oil prices.
“In the higher oil price environment, the US shale industry had traditionally been focused on growth over dividends,” says Kerogen’s managing partner and co-founder Jason Cheng. “However, since 2015 investors became more focused on free cashflow, margins and paying dividends. US shale has struggled with this transition, being a higher cost producer often with high levels of debt service.
“As a result, the sector has been broadly underperforming investor expectations, and will likely mean more consolidation. The international oil and gas sector is a diverse opportunity set industry where much lower cost and/or higher margin projects are available and generally lower leverage than the US, with a few notable exceptions. That means there is more of a buffer when there is oil price volatility.”
Kerogen has also been looking at digital technology offerings coming to the oil and gas industry to redefine work processes that reduce costs, improve productivity and increase efficiency.
“ConocoPhillips fully admits over time that it will shrink. Companies need to embrace this model,” Holt, Invesco
Investing in stressed situations or bank-led restructurings are other potential opportunities. “An example of funding stress[ed assets] we often come across is when a company cannot meet its capital calls under a joint venture and risk significant dilution or losing their interest altogether,” says Cheng. “As long as capital continues to be rationed within the industry, larger companies will continue to sell assets, so funding opportunities for small companies will be available. Buyouts and consolidation are often key themes when prices fall."
Now that oil prices have recovered from recent lows, many fund managers are more optimistic than they were during February or March and predict further price increases.
“In early April we were extremely bearish because there were so many uncertainties about Covid-19, especially its effect on emerging economies,” says Michel Salden, head of commodities at Zurich-based Vontobel Asset Management, whose fund takes active positions on commodity futures curves.
“Then we became much more bullish, because we thought the market was too pessimistic. Apart from air traffic, congestion is accelerating quicker than we expected. But we have to be very aware that there might be a second wave of the virus. The introduction of a vaccine would make us more bullish on oil, or a delay to it less bullish."
Investors should also look beyond the short term when considering the demand-supply equilibrium. As oil and gas companies have announced deep capex reductions, which will restrict future supply, there is likely to be upward pressure on prices as demand normalises, according to Christopher Korpan, a natural resources portfolio manager at JP Morgan Asset Management.
“The level of stimulus that central banks and governments have engaged in should also be positive for real assets. It is key to remain focused on the longer term, whereby increasing urbanisation of emerging markets will drive demand for commodities and be supportive for prices,” he says.
Oil will probably rise from $35/bl currently to around $50-55/bl by the middle of 2021, predicts Invesco’s Holt. “There will probably be one more super-cycle before we hit peak oil demand,” he predicts. “But companies cannot get sucked into thinking this is a growth business.”