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2017: A good year for oil

| Equity Analyst | 15 December 2017 | A A A
2017: A good year for oil

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

No recommendation

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

Having hit lows of less than $45 a barrel in the summer, Brent crude has spent the second half of the year on a steadily rising trend and looks set to close 2017 somewhere above $60.

That’s driven a recovery in share prices among oil companies. But it’s not the only factor that has made 2017 a far better year for the oil industry than many expected.

OPEC and West Texas Intermediate

The main driving force behind the oil price rise has been OPEC’s decision to maintain oil production cuts, first announced in December 2016. The degree of compliance by members of the oil cartel has also improved as the year progressed.

At the beginning of the year we flagged concerns that a surge in the oil price would see US shale drillers return to the well head. The extra supply from US shale would, so we reasoned, mean that oil would struggle to get much beyond $60 a barrel.

That hasn’t happened to the degree we expected, with the number of active US rigs plateauing in July despite steep rises earlier in the year. The lack of response from the frackers is probably a reflection of the widening gap between Brent crude (the most widely used global oil benchmark) and West Texas Intermediate (WTI – the most widely used US oil benchmark), which is still below $60.

There are several possible reasons for WTI’s failure to keep up with Brent, not least the impact of Hurricanes on demand from US oil refineries. But whatever the cause, it’s clear that US based frackers are selling into a lower oil price than rival global oil majors. That means the incentives to get fracking hoses out again is that much lower.

An uneasy truce

So what does the future hold for oil prices?

Well if the last few years have taught us anything, it’s that calling the direction of travel for oil prices with any degree of accuracy is very difficult. However, to us, the current rosy conditions feel more like an uneasy truce than a new normal.

There’s been speculation for some years that we are at, or near, the peak for oil demand. Although total demand for oil certainly hasn’t peaked yet, with growing and increasingly wealthy populations in the emerging world driving demand, energy intensity is falling. Renewable energy, carbon emission targets and electric vehicles are all playing a part in reducing the need for hydrocarbons in the long term.

Short term tailwinds aren’t guaranteed to continue either.

OPEC is a collection of countries with widely differing priorities. Throw in non-OPEC countries like Russia, which is also participating in the production cut, and it’s easy to imagine the agreement breaking down.

Meanwhile, if WTI were to recover ground on Brent, that would increase the incentive for the US frackers to get cracking.

Urgently needed oxygen

Whatever the future may hold, a higher oil price has provided oil stocks with some much needed oxygen.

Years of $100+ oil meant many groups simply weren’t prepared for a world of low oil prices. Debt had been piled onto the balance sheet and fields under development had break even prices only slightly less than $50 a barrel. A collapse in oil prices is always going to hurt oil company profits, but the scale of the fall left many producers struggling just to stay in the black.

Years of cost cutting and asset disposals mean most companies are looking in better shape now, but a stronger oil price is the fuel the industry needed.

Higher prices are most beneficial for those companies in the most straitened circumstances. It’s not surprising to see that medium-sized players with significant debt, such as Tullow Oil and Premier Oil, have performed particularly well since the oil price bottomed in mid-June.

The share price performance may not be as impressive at the big players, but we think Shell and BP have also made huge strides this year - as a higher oil price increases the amount of cash coming through the door.

Both are scrapping, or offsetting, scrip dividend programmes (where shareholders receive their dividends in newly created shares rather than cash) that we have long seen as a burden on future cash flows. BP has also turned a corner on Gulf of Mexico compensation claims, with annual payments expected to decline from here.

It’s oil, stupid!

Ultimately your investment decisions in the oil and gas space should be guided by your views on the oil price – big surprise there!

Oil bulls should look for the small players. A dollar on the oil price means a lot more to these guys than it does to the giants.

That’s partly because of the underlying improvements the oil majors have made to their balance sheets in the last 12 months. Not only are they better placed to weather a downturn than smaller rivals, but the generous dividends look more secure – although, as ever, a dramatic downturn could put them back under the microscope.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.