Oil giants such as Shell don’t need the oil price to go any higher to produce an “amazing amount” of free cashflow – but structural supply issues mean the value of the commodity is more likely to rise than fall in the coming years.
This is according to Alec Cutler, manager of the Orbis Global Balanced fund.
The last time the price of oil was above $100 (£83.4) a barrel was in 2014, when Shell was producing $25bn in free cashflow and its share price stood at $38. While the oil price has averaged $80 a barrel over the past 12 months, Shell’s free cashflow is up 72% on its 2014 level, but its shares trade at about $22.
“These energy companies are way better run than they used to be, so there is a tremendous amount of opportunity in something like Shell,” said Cutler.
“If you take the first quarter’s free cashflow and annualise it, Shell can buy back all of its outstanding stock and bonds in something like four years. It's producing an amazing amount of free cash.”
While Shell appeared to be on a strong footing in 2014, its profitability took a hit when the oil price collapsed, in part thanks to a supply glut caused by the shale boom in the US.
It is this type of volatility and the fact that oil & gas businesses are dependent on the price of a commodity over which they have no control that makes many investors shy away from the sector.
Performance of index over 10yrs ($)
Source: FE Analytics
However, Cutler said there will be no supply glut this time around.
“The saying is that the best cure for high energy prices is high prices, with capital spending rising along with spot prices, albeit with a lag effect. It’s pure capitalism,” he explained.
“But the price has been rocketing higher over the past year without any appreciable increase in investment.
“The big thing that's different this time is the ESG movement.”
Cutler said this involves institutional investors putting pressure on oil & gas management teams to ramp down production, under the threat of divestment.
Pressure is coming from other sources, too. Milieudefensie, a Dutch environmental organisation, took Shell to court to reduce its global net carbon emissions by 45% by 2030. At a May 2021 ruling in The Hague, the district court ruled in favour of Milieudefensie.
Yet conversely, Cutler said this is making oil & gas companies much better investments as it will constrain supply and ensure prices remain elevated.
“Unless there's investment, the price shouldn't come down until there's massive destruction in demand,” the manager continued.
“But a big drop in global demand is something like a 1% fall – it won't bring the price down very far.
“About 70% of the world is a developing market, where most people have never flown on an aeroplane, and half the people on the planet don't have access to cooking fuel.
“They're continuing to develop whether we like it or not and they're going to use more fossil fuels. Demand is going to be there. If the supply doesn't come to match it, prices are just going to keep going higher and higher.”
Putting this into figures, Cutler noted the global average decline rate for oil wells is 7 to 8%, meaning that if there is no further investment, there will be 7 to 8% less oil next year.
Oil & gas companies are currently spending enough to slow that decline rate to 1 to 2%, but Cutler said demand has grown at 1% a year in every one of the past 20 years, with the exception of 2020.
“Until we replace it, these things are going to continue to wander higher. That’s important, because there is still a lot of momentum around this notion that these companies will be put out of business and we won't use oil or gas anymore.
“That's just not true and it’s not going to happen for 40 years.”
He also said that many major investment firms fired their energy analysts, creating more mispricing, yet many fund managers remain wary of taking advantage of these opportunities.
“People are dragging their feet because they are scared and they don't understand what they're looking at,” the manager added.
“This could be at the beginning. We could have demand destruction that takes the prices down. But that doesn't take the prices down below $100, because the demand just comes right back. We need more supply. We're desperate for more supply.”
Not everyone is so optimistic about the prospects for oil & gas companies. Thinktank Carbon Tracker warned that more than $1trn of oil & gas assets risk becoming stranded if we are to limit global warming to 1.5°C.
It also said that when renewables eventually displace oil as the primary energy source, the decline in demand for the commodity will not mirror the steady increase over the past century or so. Instead it is more likely to follow in the path of formerly vital infrastructure assets that became obsolete almost overnight, such as canals and telegrams.