How should investors play the oil rally?

Unless global growth tails off or US shale production ramps up and floods the market, oil prices should stay strong

Oil prices surged on Wednesday following president Donald Trump’s announced his intention to pull the US out of the 2015 Iran nuclear agreement. 

With the US pulling out of the deal likely to result in the reimposition of sanctions on Iran, Brent crude hit just over $77 a barrel. Oil prices, however, have been rallying since the start of the year.

Russia and Saudi Arabia have agreed to a series of production cutbacks, while Venezuela, once one of the world’s largest suppliers, has seen its production levels collapse. Synchronised global growth has also meant strong demand. 

At the same time, markets had already been pricing in fears over tensions in the Middle East, including the possibility of the US reneging on the Iran nuclear agreement. 

As the table below shows, Brent crude oil prices have tracked BlackRock’s gulf-focused Geopolitical Risk Indicator. 

 

Buy oil equities, not oil

Unless global demand tails off or US shale production ramps up and floods the market, 2018 should continue to see strong oil prices. 

According to Richard Turnill at BlackRock, the best way for investors to play the oil rally is to gain exposure to energy equities rather than attempting to purchase oil or oil-tracking investment products. ‘For investors seeking exposure to oil today, we see a stronger case for investing in energy equities over crude itself or energy-related debt,’ says Turnill. 

While oil prices have rallied, the share prices of oil-related firms have been more subdued. As Turnill notes: ‘Oil prices have run well ahead of energy stocks this year, but this trend has started to turn.’

Added to this, oil companies’ response to the rally in prices has also been supportive. Evidence from their first quarter earnings indicates that their focus on capital discipline has been strong, says Turnill. 

‘Unlike in some past oil market rallies, companies are not making huge investments in future production. Instead, they are using free cash flow to return capital to shareholders via increased buybacks and dividends.

‘At the same time, weak oil prices since 2014 have resulted in many energy firms budgeting for $50 oil prices in 2018, putting energy companies in a good position. ‘This conservative outlook [is] reflected in share prices today. This points to valuation upside should current levels of oil prices be sustained.’

In particular, Turnill recommends looking at ‘exploration and production firms and midstream companies.’ One cheap and easy way to gain exposure to such firms is through the iShares US Oil & Gas Exploration & Production ETF. After the past month it has returned over 15 per cent, compared to the 2.3 per cent return of the broader SPDR S&P500 ETF.

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