Is it Time to Invest in Oil?

The global pandemic took oil demand down to WW2 levels, but with oil prices recovering as economies re-open, is the worst over for Big Oil?

James Gard 24 June, 2020 | 9:14AM
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Oil

At Morningstar we often implore investors to tune out from the short-term market noise when making decisions, and few sectors have been noisier this year than oil.

So far we’ve seen a chunky dividend cut from Shell, the oil price (briefly) turn negative, massive job cuts from BP and serious disagreements among Opec+ members.

The backdrop of a global pandemic, crushed oil demand, and the increasing clamour for climate change action are direct threat to the business models of oil giants. No wonder many investors are feeling spooked. 

Do Oil Prices Matter?

Investors tend to focus on the price of oil as a barometer for the global economy, which this year is in a very weak state. They also focus on crude prices because they indicate what profit oil companies can make in the good times.

In simple terms, low oil prices mean low profits for the oil majors, which means depressed share prices and lower dividend payments for shareholders. Announcing job cuts recently, BP chief executive Bernard Looney said in a message to staff: “The oil price has plunged well below the level we need to turn a profit. We are spending much, much more than we make - I am talking millions of dollars, every day."

Oil prices briefly went negative this year, at least futures contracts did, but have since recovered to around $40 as more economies begin to tentatively re-open and demand for energy increases.

With the path of the economic recovery from the pandemic hard to call, “short term oil price forecasts are impossible”, says Tom Nelson, head of Ninety One’s natural resources team.

Oil funds

Active Funds Beat the Index

When the oil price plunged in April, interest in oil ETFs spiked as some investors reasoned that a crash in prices was an attractive entry point. But, Morningstar ETF analyst Kenneth Lamont, sounds a note of caution to any opportunistic investors: there are various technical reasons why ETF prices don’t track the crude price so closely and why exchange traded commodities (ETCs) need to be treated with care.

In a tough year for equities and commodities, it’s not surprising to see active energy funds posting negative returns in the year to date. But a number of these funds - which invest in the shares of oil companies rather than simply tracking the price of the commodity itself - have managed to outperform the Morningstar Global Energy Index ($), which is down 31.38% in the year to date. The best performing, with a -5.33% return this year, is the Ninety One Enhanced Natural Resources fund.

Picking the companies that can weather the storm is key and Morningstar analyst Allen Good rates French oil major Total (TTA) because its production costs are much lower than its rivals, so can bear the current low oil price environment better. Shell (RDSB) is still rated as a five-star stock by Morningstar analysts, with a fair value of £29, which is significantly higher than the current share price around £13. Despite its dividend cut, the stock retains its narrow economic moat and has an uncertainty rating of medium. 

Path of Recovery

While the return to some sort of economic normality will undoubtedly be good for oil demand this year, Ninety One's Nelson expects sustained low oil prices to trigger a brutal shakeout of the sector. "Some companies will evolve, improve and prosper and some won’t make it”., he warns, adding that the US oil sector could be more vulnerable than in Europe, for example, where companies have embraced the transition to a low-carbon future more keenly. 

“The best companies will prevail and generate attractive shareholder returns but it will be pretty Darwinian for those who are stuck with old world business models and weak balance sheets," he says.

Could the worst be over for the better capitalised oil firms? Stuart Clark, portfolio manager of WealthSelect at Old Mutual Wealth, argues that the worst-case scenario has already happened this year. And, while many Big Oil firms are making big strides in addressing climate change and the energy transition, the world is still a long way from being able to use 100% renewable energy. He adds: "The writing is on the wall for Big Oil but it’s always going to be part of the energy supply."

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James Gard  is content editor for Morningstar.co.uk