The investment case for oil has had its ups but mostly downs this year, with investors taking a stand-off approach so far in 2017, such that the MSCI ACWI Energy sector is down some 13 per cent. This decline has come as the price of Brent crude – which has seen 20 per cent wiped off its value in the first half of this year – officially enters a bear market.
Taking a step back and looking at the bigger picture of the oil market, we should remember that the oil price was comfortably above $100 a barrel less than three years ago. Although it has risen from its trough of early 2016, when it fell to $28, its revival has petered out. Optimism about concerted action to reduce the supply glut has subsided, as OPEC’s recent cuts have failed to eliminate the surplus.
Turning to the US, the scene doesn’t look any rosier, with the number of rigs operating in US fields having more than doubled over the past year. Many shale wells have been taken offline because of the slump in the oil price, but these can be brought back to production very quickly – sometimes in as little as a week – and some are now able to pump profitably at $40.
Taken as a whole, the above scenario might be taken as a clear sign to stay away – for most investors, that is. The consensus is that the oil price will be low for the foreseeable future, and so that consensus would suggest that oil companies are an unwise investment.
However, against this clear overarching school of thought to steer clear, there are opportunities afoot that should not be overlooked. One of the clearest reasons for investors to give oil a second look is that the world remains heavily reliant on fossil fuels. Yes, there’s a lot of oil around at the moment and yes, its price is not what it was – but just because a commodity is plentiful doesn’t mean that it isn’t needed.
What matters to the companies that produce it is not so much what the oil price is at any given point, but how they are able to stay competitive and – crucially – profitable. Already, the precipitous oil-price decline of recent years has flushed out many of the sector’s weaker operators. That means that the surviving companies have come through a ferocious phase of natural selection. Indeed, the oil majors are leaner than they have been for decades.
Three oil firms I'm holding
So what have these companies been doing to cope with the downturn in oil prices? There are several examples in our portfolio of companies that are finding ways to thrive, all of which we class as ‘ugly ducklings’ – unloved shares that most investors shun.
Royal Dutch Shell is one of these. It has reduced its net debt by selling off surplus assets, giving it an increased focus on deep-water oil and integrated gas projects. The company now offers strong free-cash flow generation, supporting the attractive dividend yield which is now paid out of income rather than capital.
Another example is Total. It has been focusing on securing its long-term growth through acquiring low-cost producers in the Middle East and Brazil. This minimises the need to undertake expensive exploration. Like Royal Dutch Shell, Total has been selling off non-core assets, reducing debt and focusing on free cash flow.
Canada’s Suncor is also well placed to produce oil profitably even when the price is low. The company has extensive oil-sands reserves, and the peak of its capital expenditure is behind it. Importantly, it acquired significant assets at a time when the oil price was lowly priced.
All of these companies trade on attractive valuations. Furthermore, given the ever-growing need and increasing demand for energy, the sector offers an undervalued opportunity – particularly when considering there is currently no viable alternative to oil on the market, effectively, leaving the sector with no competition.
Finally, we should remember that nearly everything is cyclical. Given the world’s reliance on fossil fuels, history shows us the sector will come through its current malaise. We can be assured that those companies that have weathered the downturn well will be best placed to reap the benefits when the price of oil recovers.
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