Oil: A Once-in-a-Generation Investment Opportunity?

Contrarian fund managers are bullish on the outlook for oil companies. We run down the investment case and pick out a few stocks and funds to play the sector

David Brenchley 25 January, 2018 | 9:35AM
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BP and Shell have high yields, but are they sustainable?

As the oil price continues its unlikely comeback, so too has the investment case for the commodity.

It’s billed by many as the ultimate contrarian call; a sector that is deeply unloved these days. But there may now be enough fund managers bullish on the prospects for oil and the companies involved in its production to dampen that claim somewhat.

We’re now past the worst of an extreme bear market for oil prices, brought on by a glut of crude oil. Brent crude fell from trading well above $100 in 2014 to bottom out late 2015 at less than $30. It’s since more than doubled to a shade below $70 at the time of writing, and has rallied 45% since July.

“In the middle of 2016, universally the view was that the oil price was going down,” says Stuart Rhodes, manager of the Morningstar Silver rated M&G Global Dividend fund. “The view then was that electric vehicles are coming, the oil price is toast, it’s a dead industry, it’s finished – why would anyone invest in it?”

Rhodes disagrees: “It never was a dead sector. In 2015 and 2016 you got investment opportunities in a part of the equity market that you get once every generation.”

While the opportunity now is no longer to that extent, there are still plenty of attractive investments in the space. And there is a clear fundamental story around why things are rapidly improving in the sector.

The supply side has stagnated after years of under-investment due to the price crash production cuts from OPEC countries. Thomas Moore, manager of the Standard Life Equity Income Trust (SLET), notes that new oil discoveries are at their lowest levels since the 1940s.

This has helped demand catch up to a point where, now, “we are pretty significantly undersupplied”, according to Rhodes. It took three or four years for demand to correct, he continues, and it’s going to take at least that long, if not longer, to return to an over-supply situation.

Further, the threat of electric vehicles to internal combustion engine cars are overblown – in the short term, at least. Around 60 million cars are produced worldwide each year, but fewer than one million electric vehicles are sold.

Electric vehicles will overtake internal combustion engine cars at some point, but Rhodes says it’s “almost mathematically impossible to assume a scenario where gasoline demand doesn’t go up every single year to the year 2025”.

So, where are the investment opportunities?

Oil firms have long been prized for their income-producing qualities. “Ultimately, often in resources companies the dividend is all you get out of the company at the end of the day,” says Michael Hulme, manager of the Carmignac Portfolio Commodities Fund.

What About the Oil Majors?

The obvious starting point are the big guns, which, where UK investors are concerned, be Royal Dutch Shell (RDSB) and BP (BP.). Both yield around 6% and Shell has not cut its dividend since the second world war.

But many doubt the payouts of the oil majors. Ever since the crash, both BP and Shell have been either borrowing to fund their dividend, or paying the dividend by issuing extra shares, known as a scrip.

But they have also been busy cutting costs aggressively and repairing their balance sheets.

Steve Clayton, manager of Hargreaves Lansdown’s Select UK Income Fund, says Shell’s “unparalleled track record for paying its dividend through thick and thin” is “reassuring”.

Moore says the firm’s yield premium is currently over 50% versus the FTSE All Share, as opposed to 26% typically. That means “the stock’s got some re-rating potential”.

Alec Cutler, manager of the Orbis Global Balanced Fund, says the fact that Shell and BP are “integrated” majors means they are not as dependent upon the oil price as others. This is because their business “spans the whole value chain”.

He says: “Their upstream units drill for oil, their midstream units transport it, and their downstream units refine and market it. Of these segments, only the upstream depends directly on oil prices for its profits.”

Avoid the Obvious Stocks

Despite having a dividend-focused remit, Rhodes says he steers clear of BP and Shell, due to dividend worries. Instead, he focuses on three other areas of the industry - Petrochemicals, energy infrastructure and oilfield service providers.

The latter two are particularly interesting for Rhodes, as it houses two companies he is bullish on – US-listed Schlumberger (SLB) and Canadian Pembina Pipeline (PPL).

The latter, he says, trades on a cash flow yield of near 10%, which is “very cheap”. “There are very few companies in the world that trade, without a real problem, above a 10% free cash flow yield. Something like a Unilever would be around 4% at the very best.”

Similar comments on cash flow yield apply to Schlumberger. “We’ve never had a period in recent memory where oil investment’s gone down three years in a row, but we hit that last year. If we don’t start increasing activity soon then we’re going to hit some major problems in a couple of years’ time.

“Schlumberger is the company around the world that pretty much touches every barrel of oil in production.”

They are currently “lightyears” away from what they used to earn on cash flow back in 2013 and 2014, he adds. “If we got anywhere near back at what the previous peak was, then it’s trading at an obscenely low cash flow yield.”

Permian Basin Offers Opportunities

Hulme sees value in companies with operations in the Permian basin. He says that the scale of this resource is vast – second only to Ghwar in Saudi Arabia in reserves.

It’s also well positioned – Texas is “a factory for oil”, has light-touch regulation and some of the best experts are located in Dallas and Houston. And the rock found there is “one of the richest in shale in the world” – “in the same square mile of land you can drill 10 times as many wells” than in most shale other plays.

One example of a company Hulme invests in is exploration & production firm EOG Resources (EOG). Hulme calls EOG “the Daddy Fracker”, pulling on hedge fund manager David Einhorn’s description of Pioneer Natural Resources (PXD) as “the Mother Fracker”.

Other examples include PDC Energy (PDCE) and Cimarex Energy (XEC).

Sustainably Investing in Oil

David Osfield’s Edentree Amity International Fund is run with a socially responsible bent, but the manager is still keen to have a play on oil prices.

He says that while “the EV train, or car, has left the garage” and we’ll see “continued demand destruction for crude” in cars, it will still be in demand for aircraft and other forms of transportation.

His play on higher oil prices this is UK-listed Victrex (VCT), which makes PEEK, a high-performance plastic used as a titanium alternative in aircraft. “If the oil price goes higher putting lightweight materials into vehicles like Boeing saves much more money.”

Funds Picks

Those with an UK equity income fund probably already have some exposure to oil through Shell and BP.

Russ Mould, investment director at AJ Bell, says the active River & Mercantile UK Equity Income Fund has big positions in both. For passive exposure, the iShares Core FTSE 100 ETF (ISF) will give investors exposure to energy to the tune of 16.1%.

A pure play energy fund suggested by Mould is the Morningstar Silver rated Guinness Global Energy. Performance can have sharp swings, as shown by its two-star performance rating; but analyst Fatima Khizou says that’s par for the course in this sector.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
abrdn Equity Income Trust Ord301.00 GBX2.73Rating
BP PLC539.10 GBX3.67Rating
EdenTree Responsible & Sust Glbl Eq B364.20 GBP-0.30Rating
EOG Resources Inc135.29 USD-1.44Rating
Guinness Global Energy Y GBP Acc13.82 GBP-0.34Rating
HL Select UK Income Shares A Acc120.21 GBP-0.12Rating
iShares Core FTSE 100 ETF GBP Dist781.90 GBX0.93Rating
M&G Global Dividend GBP I Acc517.33 GBP-0.71Rating
Orbis OEIC Global Balanced Standard22.74 GBP0.11Rating
PDC Energy Inc  
Pembina Pipeline Corp47.83 CAD-0.37Rating
Pioneer Natural Resources Co270.80 USD-1.43Rating
SLB52.00 USD-3.70Rating
Victrex PLC1,290.00 GBX-1.98Rating

About Author

David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk

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