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The case for and against buying oil stocks, by Liontrust

30 January 2017

Liontrust fund managers Stephen Bailey and Samantha Gleave outline the reasons for and against investment in the oil stocks in 2017.

By Jonathan Jones,

Reporter, FE Trustnet

Investing in the energy sector continues to divide many fund managers despite the recent pick-up in commodities prices. 

The sector has faced a number of challenges until relatively recently, and has yet to convince investors that past troubles are behind it.

Indeed, energy has been one of the most contentious sectors over the last five years as oil prices plummeted from a high of $130 per barrel in 2014 to a low of less than $30 last year. Prices currently sit at around $55 per barrel.

Market performance justifies some of the wariness to a market sector that has underperformed the broad FTSE All Share index more recently.

While the FTSE All Share index has risen by 130.58 per cent over the past five years, the FTSE All Share Oil & Gas index has risen by just 21.48 per cent.

Performance of indices over 5yrs

 

Source: FE Analytics

Unease over the sector has come at a time where investor sentiment has been clouded by external challenges and geopolitical upheaval.

“In this modern world the market is more polarised than perhaps it has been since the financial crisis,” according to Stephen Bailey, manager of the Liontrust Macro Equity Income fund.

Bailey argues that investors need to take a more specific approach to investing than has been previously warranted.

“We’re looking at markets that are moving in a generally positive direction but its very sector specific so it’s becoming very important where you are invested but it is as important where you are not invested,” he explained.

While investors have plumped instead for defensive stocks and “bond proxies” in the utilities, pharmaceuticals and consumer staples sectors, some managers are beginning to argue for greater exposure to the energy sector.

Below, Liontrust managers Bailey and Samantha Gleave consider the pros and cons of investing in the sector this year.

 

Against

Equity income managers will be well aware of the challenges of investing in the sector. For some managers, dividend-paying FTSE 100 stocks such as Royal Dutch Shell and BP are a key component of income strategies.

“This has become a very common holding among equity income funds,” said Bailey. “Four out of every five equity income funds have exposure to Royal Dutch Shell and of course the sector is dominated by Shell as well as BP.”

Bailey said his fund had held one or both of the stocks every year since 2003 until selling out of the stocks in recent years.

Despite an uptick in oil prices recently, prompted by a cut in production levels by members of oil cartel OPEC (Organisation of the Petroleum Exporting Countries), Bailey says the energy sector remains exposed to “very negative macro influences”.

The biggest risk, the fund manager says, is due to the supply-demand imbalance that has impacted the sector for a number of years.


“We recall back in 2014 when the Saudi’s decided to adopt an open-cap strategy to oil production in order to put pressure on the emerging US shale business.

“At the time the price of crude oil was up at around $100 per barrel and quickly slumped in the next 18-24 months down to below $30 per barrel.”

Performance of Brent crude over 5yrs

 

Source: FE Analytics

“In 2014 the price of producing a barrel of shale oil was approximately $70, so it wasn’t exactly a low-cost option and the Saudis successfully shut down a great deal of capacity in North America.”

As a result, he says, Saudi efforts pushed back oil majors in the US for a short time allowing prices to stabilise, and with new agreements at the end of 2016 by the OPEC member countries to cut production, sentiment was beginning to reverse for oil producers.

However, Bailey warns that OPEC no longer has as much power as it used to, with the growing ability of Russia, Brazil and the US shale industry to set prices.

“OPEC are now only responsible for 40 per cent of total production. When you look at it a bit more closely there are other things you need to take into account,” Bailey said.

“There is still an overhang in supply that is perhaps in storage or by speculators of approximately 800,000 barrels a day. Estimates suggest it could take six-12 month from that to actually disappear from storage.

“We have two very keen producers in Nigeria and Libya which are exempt from those cuts and if they were to return to peak production you are looking at an additional 1.3 million barrels of oil per day coming on the market.”

He adds that non-compliance from member countries has also been a problem in the past. Since 1992, OPEC members have produced more than their quota 60 per cent of the time.

US president Donald Trump has also been steadfast in his support for growth of the US energy sector.

“We are all aware he wants to ‘make America great again’,” said Bailey. “He wants to make America independent in terms of its energy needs and also I think one of the things we’re going to see is that his energy policy has been a very central facet of his administration.”

The manager says at its peak, US shale was producing nine million barrels of oil every day and while it may take some time to get back to those levels, these companies have been slashing costs in the interim to ensure a more cost-effective business.

“Recent evidence suggests that we have seen the rig count double in size – from a very low base albeit - but the cost of production now sits at between $35 and $50 per barrel substantially lower than 2014,” he said.

“This means that the upside for the price of crude is going to be somewhat limited because if it stays above $50, the shale business in the States remains incredibly profitable and there is every reason to expect higher production to follow.”


For

However, Bailey’s colleague Samantha Gleave, manager of the Liontrust Global Income fund, has an “alternative view on the energy sector”.

“We focus on the financial evidence – not on opinions or on forecasts,” she said.

“At the end of 2015, more energy and mining companies had moved into the top decile of cashflow screens, while pharmaceutical companies had moved into the bottom decile.

“The first positive was all these energy stocks appearing in our cashflow screen.”

“The second positive was capex,” she said. “In 2015 there was a reduction in capex – in fact capex collapsed as the oil price cracked the management in the sector took a much more prudent approach towards capital allocation. Capex is still falling today and it needs to.

“The third positive regards the level of pessimism in the sector. Compared to the last 30 years, management are more pessimistic about future growth expectations and what we found is when managements are very pessimistic about the future, in fact this is a very good contrarian indicator.

“The fourth positive we saw in the sector was valuation. Over the last 30 years, by the end of 2015 the sector had reached a new low in valuations and we felt that was very attractive.”

Indeed, a look at some of the largest stocks in the market show that their share price over the past five years have remained relatively flat.

Price performance of stocks over 5yrs

 

Source: FE Analytics

BP has risen just 4.79 per cent while Royal Dutch Shell has lost 1.1 per cent from its share price over the last five years.

“The fifth and final positive regards valuation spreads. The spread between the cheapest stocks in the sector relative to the average is a measure of investor concern.

“Spreads widened very sharply in 2015 as investors honed towards the highest quality stocks in the sector and shunning those that appeared far more risky. Again this is a very good contrarian indicator,” added Greave.

“Taking all this financial evidence together we bought into the energy sector and today our view on the sector is still positive though we think probably a more selective approach is required. “

Yet, despite her more positive appraisal of the sector, Greave investors should stick to those oil stocks that are on a “strict capex diet”.

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