Oil & gas shares – why green is the new black

2020 will always be the year of the global pandemic, unless current events in Asia mean 2021 claims that undesirable title. But had the pandemic never happened, might we instead be looking back at 2020 as the year oil groups went green?

Ok, that might be a bit of a stretch. After all, it was the pandemic which caused the oil price to fall into negative territory for the first time ever. This forced oil & gas groups to look at other ways to keep cash coming in. But still, 2020 was a watershed year for the industry when it comes to looking beyond traditional hydrocarbons.

This article isn’t personal advice. If you're not sure if an investment is right for you, please seek advice. The value of all investments and any income they produce will fall as well as rise, so you could get back less than you invest.

Sudden shift to sustainability

It would be nice to think oil & gas groups felt a moral obligation to go green. And maybe they did. But there are a few harder and more practical reasons the industry is looking at shifting its focus too.

We’ve already touched on the first. During the peak of the Covid-induced stock market crash last year, the oil price plummeted. It fell from $58.50 a barrel in late February to briefly going negative in April. That was driven by a mix of increased supply from Saudi Arabia and Russia, and a lack of demand as economies locked down to fight coronavirus.

Oil majors have weathered price falls before. But generally the big players have low enough production costs to stay profitable at low prices, or financial firepower to weather a short downturn until smaller players go under. Those strategies start to look riskier when there’s no floor to the oil price. Especially given oil volatility has stayed higher since the short-term spike last year.

The CBOE Crude Oil Volatility Index measures the movement in oil prices. So, when the market is uncertain and oil prices fluctuate more rapidly, you’d expect volatility to be greater. Since June 2020 it has had an average reading of 42. That’s significantly higher than the 2011 to 2019 average reading. Even by digging into 2019, which was a relatively rocky year by recent standards, the 2020 average is still significantly higher.

Volatile oil prices make it difficult to plan, and even more difficult to commit to the multi-billion dollar developments necessary to get a new oil field online.

Source: Refinitiv, 29/04/2021.

So why all the extra volatility?

In late 2020, BP suggested global oil demand might have peaked in 2019. It’s a conclusion that has since been echoed by other industry players. In reality, it doesn’t matter all that much if oil demand in 2021 or 2022 is higher than 2019. What matters is the trend and are we at the start of a longer decline in oil demand?

We think increasingly carbon conscious governments, consumers and businesses are a large part of the answer. But so is the global slowdown in population growth and slower economic growth in emerging economies – both trends that started before coronavirus. The long-term drivers for oil demand aren’t as strong as they once were, just as others are looking to lower their consumption.

Of course, oil consumption isn’t going to disappear overnight and gas is expected to remain a major source of energy well into the 2050s and beyond. That said, falling global demand for oil is clearly a powerful incentive for oil & gas giants to look at alternative ways to earn a living.

The final reason oil & gas companies might be looking at renewables with interest is less highbrow, but also perhaps more compelling if you’re on an oil & gas company board.

To understand it further, we can look at the tobacco industry.

Chart showing change in share price for the four largest listed tobacco groups (rebased at 29/04/2016)

Scroll across to see the full chart.

Past performance isn’t a guide to the future. Source: Refinitiv, 29/04/2016 - 29/04/2021.

Shares in tobacco companies have taken a bit of a battering in recent years. Falling on average 38.8% over five years to 29 April 2021.

Normally you would have expected that sort of performance to reflect a collapse in profits. But the tobacco industry has, generally, seen its profits rise over the same period. Among the four largest tobacco groups listed in the graph above, profits rose an average of 14.0% between 2016 and 2021. What’s going on?

The answer is that investors have become increasingly unwilling to pay the same kinds of multiples for tobacco groups they once were. As you can see from the graph below, there has been a steady downward trend in price-to-earnings (P/E) ratios across the industry. The decline has been more than enough to offset growth in profits.

Chart showing P/E ratios for the four largest listed tobacco groups

Scroll across to see the full chart.

Past performance isn’t a guide to the future. Source: Refinitiv, 29/04/2016 to 29/04/2021.

In our view, the main reason for this trend is increasing hostility to tobacco among investors on ethical grounds. The UN’s Tobacco-Free Finance initiative has 162 signatories covering $11trn dollars in assets under management, and the number of individual funds avoiding the industry on similar grounds will be even greater. That’s an awful lot of money which is now not chasing tobacco stocks. The result was an inevitable fall in valuation and share price. It should be remembered past performance is not a guide to the future and oil and gas is a different sector and could behave very differently.

What’s next for oil & gas companies?

There are some rumblings that a similar investment shift could take place in oil. The European Investment Bank will no longer fund oil, gas and coal projects from the end of 2021, and other polluting assets have already seen large investors pull out.

The boards of oil majors might’ve looked at their share prices over the course of 2020 and feared they were facing the same fate as tobacco. The graph below shows the price-to-book ratios for five of the world’s largest oil companies over the last three years – you can see a clear industry-wide slide in ratings. As with all ratios though they shouldn’t be looked at in isolation.

Chart showing Price-to-Book ratios for the five largest oil companies

Scroll across to see the full chart.

Past performance isn’t a guide to the future. Source: Refinitiv, 29/04/2018 to 29/04/2021.

For oil companies which are share price conscious, there’s a clear incentive to get environmentally concerned investors on side. Failing to do so could encourage investors to look elsewhere.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. 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.

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