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Why Alex Wright bought BG Group after the Shell deal

30 April 2015

Fidelity’s Alex Wright says that bombed-out oil stocks aren’t an automatic buy, but reveals why he bought BG Group after Shell announced a deal to acquire the firm.

By Alex Wright ,

Fidelity

The recent high profile deal between Shell and BG – coupled with the recent volatility in commodity prices – has brought the oil sector firmly back into focus.

As the chart below demonstrates, the price of oil has collapsed by over 50 per cent in a little over six months. Whilst I remain underweight the oil sector, I do have some exposure and oil and energy stocks now make up around 6 per cent of the Fidelity Special Situations fund and slightly more for Fidelity Special Values PLC.

Dollar price of Brent crude since February 2014

 

Source: Datastream, as at 31 March 2015

The sector has suffered a significant sell-off since last summer when the price of oil started to fall, with companies with high costs of production in particular suffering.

However, now that there appears to be some price stabilisation, is it time pick up oil or oil-related companies at attractive valuations?

It is not quite as straightforward as that.

Firstly, many companies in the sector aren’t as cheap as one might expect given the significant fall in share price they experienced. Many share prices already imply some recovery in the price of oil, meaning that if none materialises, downside risk exists. This is particularly the case for companies with a higher cost of production.

Secondly, many companies that look attractively valued and have lower costs of production are smaller-cap stocks. These companies are often highly specialised and concentrated geographically. Whilst from a fundamental perspective the investment case may look attractive, a small position is usually most appropriate.

I look to manage this risk in my funds by taking a diversified approach. Together with Fidelity’s team of analysts, I have identified a number of smaller companies with low oil production costs and strong balance sheets.

Whilst on an individual level each stock is too exposed to particular extraneous factors, together they are sufficiently diversified and this provides me with comfort that no one single geo-political or other shock can have a significant impact on portfolio performance. Names I hold here include the likes of Genel, Nostrum and Faroe.

What I particularly like about these positions is their low cost of production. If the oil price doesn’t recover they should still be able to operate profitably, thus offering adequate protection on the downside whilst still enabling me to benefit from any medium-term recovery in oil prices.

Following Shell’s stock and cash offer for BG Group we have recently initiated a position in BG. I believe this represents the cheapest way to access the improved investment proposition the enlarged Shell group now offers. Our view is that the deal is likely to complete, which offers an arbitrage opportunity between the two stocks at current prices.

For Shell, the deal consolidates its position as a global leader in liquefied natural gas (LNG) markets. As LNG is a relatively clean source of energy, this is a valuable strategic position to occupy. It also considerably improves Shell’s production growth prospects, although clearly this is a longer-term story as we wait for BG’s Brazilian assets to move towards production.

In terms of downside protection, Shell has managed to put this transformative deal together without impairing its balance sheet, which is some achievement. The 6 per cent dividend yield looks safe, particularly when you consider that the company hasn’t cut its dividend since the Second World War.

Alex Wright is portfolio manager of the Fidelity Special Situations fund and the Fidelity Special Values investment trust. The views expressed above are his own and should not be taken as investment advice.

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