The price of Brent crude oil has fallen significantly in the past 12 months, oil stocks have lagged the broader market and the sector has been shunned by investors concerned about environmental, social and governance (ESG) factors.
Despite this, more than half (56.8%) of funds in the IA UK Equity Income sector count Shell as a top 10 holding while 45.9% can say the same for BP. Retail investors are piling in as well; BP was the most bought stock on interactive investor’s platform in October.
BP has had a particularly bad year, culminating last week in its worst quarterly results since the pandemic. Its share price is down 18.4% year-to-date, according to Google Finance. Shell has fared better and is up 1.6% year-to-date, as of mid-morning today.
Both stocks rose this morning on news that OPEC would delay hikes in output through December, giving oil prices a lift, said AJ Bell investment director Russ Mould.
With geopolitical tensions on the rise, supply/demand imbalances working in energy companies’ favour and valuations outside the US at attractive levels, this might be a good time for contrarian investors to take a fresh look at the sector, he suggested.
Demand for oil is growing but supply is constrained
Demand could surge in the US especially, Mould argued: “The US Strategic Petroleum Reserve is still diminished, at 385 million barrels, way below its 714-million-barrel capacity, after the Biden administration’s liquidation of assets to try and cap fuel and gasoline prices for US consumers. At some stage it would make sense to top this back up, especially at a time when energy supply could be a matter of national security.”
But while demand is robust, supply is constrained. “Drilling activity remains subdued, thanks to the pricing environment and the combination of political and public pressure,” he noted.
Redwheel’s Ian Lance, who manages the Temple Bar investment trust, said the capital expenditure of the 50 largest oil companies in the world today is half that of 2013, so companies are investing less, even though “demand for fossil fuels this year is at an all-time high”.
“We sometimes refer to this as a capital cycle thesis, where supply is not growing, but demand continues to grow,” he said.
The energy transition is weighing no BP
Long term, the transition to renewable energy should dampen demand for oil but that has not happened as quickly as expected, Lance said.
Of all the oil majors, BP “went heaviest on the energy transition”, said AJ Bell's head of financial analysis, Danni Hewson. Paradoxically, it has been penalised for this.
US oil majors, which have performed better, have taken a “more pragmatic approach”, making no plans to move out of hydrocarbons, having no interest in renewables and focusing instead on complimentary areas like carbon capture and hydrogen, she said.
Lance added: “US companies have been merging and buying other oil and gas producers, so they have not invested so much in the transition. They've continued to invest in oil and gas and therefore they've remained very profitable. They've been using that money to buy back their shares.”
Recently, BP and Shell have started to move in the direction of their US peers, he continued. They have dialled back their spending on renewable energy, invested in upstream oil and gas, and bought back shares.
Shell has outperformed BP, Hewson said, because it built a long-term strategy around natural gas, which is seen by some as a bridge between more polluting fossil fuels like coal and oil and renewable energy.
Reasons to invest in oil companies
Imran Sattar holds Shell in the Edinburgh Investment Trust but admits it is not his highest conviction idea. Oil companies are price takers – they are dependent on commodity prices which they do not control – whereas he prefers to invest in price-making businesses. However, Shell plays two roles in his portfolio – to generate income and diversify the trust’s economic exposure.
Another compelling reason to revisit Shell and BP is their valuations. They are trading on 7x earnings, with a 15% free cash flow yield and dividends of 4.2% and 6.5%, respectively.
Jonathan Waghorn, portfolio manager of Guinness Global Energy, said another way to look at valuations is the implied oil price as a barometer of the expectation priced into oil companies.
“At the end of September, we estimated that the valuation of our portfolio of energy equities reflected a long-term oil price of around $66 a barrel,” he said. This is significantly lower than the ‘normalised oil price’, which would allow supply and demand to be broadly in balance going forward, and which he believes is around $80 per barrel.
“If the market were to price in a long-term oil price of $80 a barrel, it would imply around 50% upside [to his fund’s portfolio]. Assuming an average Brent oil price of $80 a barrel in 2024, we estimate a free cash flow yield of over 10% for our portfolio.”
Guinness Global Energy is overweight European integrated oils, Canadian integrateds, equipment and services. “We believe that a new investment cycle in oil and gas is required and that our overweight service exposure will be a key beneficiary of increased spending in the sector,” Waghorn explained.
In Europe, the fund is overweight Eni, Repsol, OMV, Galp and Equinor, which are trading at valuation discounts to their global peers and are offering significant free cash yields at current share prices, he continued.
Canadian integrated oil stocks are cheaper than US counterparts thanks to lower Canadian regional oil prices. Conversely, the fund is underweight Exxon and Chevron, which trade at a significant premium to European majors.