Energy equity valuations are driven both by the prospects for long-term energy commodity prices – both oil and gas – and the activity and earnings of individual companies. So what’s prompting the change in sentiment after a few years or relative underperformance?
As regards the macro environment, on the supply side the recent rise in Iraq of the Sunni enclave known as ISIS has been a useful wake-up call.
Performance of indices Jan 2011 to Jan 2014
Source: FE Analytics
For nearly three years investor sentiment was dominated by the rise in US shale oil production. Attention is now rightly focusing again on the other key determinants of supply and demand.
The recent ISIS surge comes as no great surprise. We voiced our concerns about the threat it posed to Iraq and Syria in January. No-one can predict how far it can expand or how quickly it will be crushed – if ever. Our tentative view is to assume it will not be defeated any time soon, as support from the disaffected general Sunni Iraqi population will be considerable. This reflects the blatant sectarianism of Nouri al-Maliki, the Shiite Iraqi prime minister, since the US left Iraq two years ago.
But it will likely be contained in the area it currently controls, and will rule over this area centred on Jazeera and covering much of Western Iraq and Eastern Syria for quite some time.
Current oil production in Iraq of perhaps 3.25 million barrels per day equates roughly to 4 per cent of global usage, and makes it the second largest OPEC supplier. Iraqi production includes roughly 150,000 barrels per day (b/d) in the central region, which will likely be totally disrupted.
The 700,000 b/d production in the north and 2.4 million b/d in the south, however, should be relatively unaffected, provided the conflict does not expand seriously either through Baghdad or into Kurdistan. The immediate effect on oil supplies will therefore be the loss of £150,000 b/d.
If we are right, the immediate effect on world oil supply will be surprisingly modest. A more likely consequence is that the general uncertainty will greatly hamper efforts to grow Iraqi production in the south. The loss of a rise in Iraqi production and exports is enough to justify the current move up in the oil price by $5 per barrel, but there is no logical reason why it should rise much more.
Another consequence of this development may be to encourage the transfer of control elsewhere in the Middle East to similar extreme Islamic hands; for example in Libya.
One final consequence of a successful establishment of ISIS that should not be entirely discounted is the possibility it destabilises Saudi Arabia. A recent press comment read as follows:
“The kingdom has good reason to fear the revival of an al-Qaida-like group with wide territorial ambitions. The government claims to have broken up a terrorist cell in May that had links to both ISIS and al-Qaida in the Arabian Peninsula. ISIS has also reportedly launched a recruitment drive in Riyadh.”
That would be really earth-shaking. No-one is discussing it, but if Saudi now turns against ISIS – a quite likely development – we should not rule out that ISIS survives and garners Wahhabi support inside Saudi Arabia and topples the monarchy. That would be truly disruptive.
Regardless of how these scenarios unravel, the overall impact of the ISIS crisis is to highlight that supply growth from OPEC over the next few years is increasingly challenged by political uncertainty – and not just in Iraq.
And so to demand. Demand growth is, if anything, accelerating. OECD economies are recovering and the demand in emerging economies is hardly affected by the slowdown in China.
Indeed, the transition from infrastructure investment-led growth to consumption-led growth in some emerging economies including China may actually increase demand growth.
Amidst the market’s fixation with increasing supply from US shale, the long-term fundamentals of tight oil supply and rising demand have been largely ignored, creating a significant and now long-lasting lag between current oil prices and the market’s long-term expectations – as expressed in five-year futures prices.
Brent oil price expectations 2009-2014
Source: FE Analytics
Future expectations of oil prices are a big factor in energy equity valuations. We believe that, as the world now comes to terms with $100 oil, this year’s increase in five-year forward oil prices from $87 to $98-per-barrel for Brent, has been a key factor in the change in sentiment on energy equities and their notable upturn in relative performance.
Performance of fund, sector and index over 1yr
Source: FE Analytics
Finally, the micro. At company level there are fundamental corporate reasons to be optimistic right now about energy-producing independent oil and gas companies, as opposed to national oil companies.
In part this is because the slowdown in OPEC supply growth means the supply growth baton is passing back to them.
In addition, over the last five years their return on capital has been declining as development spending ramped up to meet their supply goals. That decline is now in the process of reversing. As long as companies do what they say they will in terms of improved cost control, lower capex and a strategic shift to focus more on oil-producing assets, then their return on assets and free cash generation will start recovering.
Improving return on capital has historically been a key driver of share price performance from energy stocks; by reducing their capex after recent high development spending, energy companies are poised for another such improvement.
As these improving macro and company-level factors in the energy sector have now come together, the change in equity valuations could be significant. We estimate we are still in the early stage of a strong snap back.
After three years of relative underperformance, we believe energy equities will be a good way for investors to get outperformance in the second half of 2014 and for some time thereafter.
Jonathan Waghorn (pictured on page one) is the manager of the Guinness Global Energy fund. The views expressed here are his own.
FE Trustnet will look at ways to get exposure to the recovering energy sector in an upcoming article.
