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Investing in oil

Your introduction to the energy markets

Important - The value of investments can fall as well as rise, so you could get back less than you invest, especially over the short term. The information shown is not personal advice, if you are unsure of the suitability of an investment for your circumstances please contact us for personal advice. Oil is a specialist area so any investment should be made as part of a diversified portfolio.


Nicholas Hyett

Equity Analyst

Why oil?

There are only two oil companies in the FTSE 100, but they pack quite a punch.

The sector makes up 22.2% of the market value of the UK’s premier index and last year the two giants, BP and Shell, paid $23.5bn in dividends. If you invest in a UK tracker or income fund, the chances are a lot of your money is tied up in oil.

Oil matters.

Drilling down into the industry

In this series we take a look at how things stand with the black stuff.

The outlook for oil prices is less certain than it has been for some time – with politics, technology and the environment all playing a part. And it’s a specialist area, so any investment should be made as part of a diversified portfolio.

A delicate balance – oil prices

Oil companies, big and small, are picking themselves up after a crisis that saw prices drop 75%, from $112 a barrel in July 2014 to $28 in January 2016. Much of the heavy lifting’s done, so does that mean there are opportunities for investors?

Investing in oil – majors and minors

Finally we look at what the future might hold for energy markets. Do renewables spell the end for oil majors, or does fracking put us on the verge of a golden age for hydrocarbons?

Other ways to invest – the shakeup

The great oil mismatch

Before we talk about the outlook for oil in more detail, take a look at the charts below. They’re from BP, and give the geographic breakdown of oil consumption and oil production.

Oil consumption by region

Oil production by region

Source: BP.

*Commonwealth of Independent States.

Apart from North America, the biggest producers don’t use anything close to what they make. They also show a couple of important long-term trends. Middle Eastern production is rising, coupled with increased consumption in Asia. But what does this mean for prices?

A delicate balance - oil prices

Nicholas Hyett

Equity Analyst

A delicate balance

Oil is produced in very different places to where it’s consumed. It’s a good starting point that helps explain why oil prices are so slippery.

The Middle East is by far the biggest producer of oil, compared to oil consumers like Europe and North America, who produce relatively little. The mismatch between supply and demand has been exaggerated in recent years by the massive increase in demand from developing Asian economies like China and India.

Oil production relies on a delicate balance. When that balance is upset, the consequences can affect us all.

The 2014 crash – totally fracked

Between 2011 and 2014 US oil production rose by 15.8% a year to just under a tenth of the global total. That compares to 4% a year in the previous three year period, with US oil making up barely 6.5% of global output in 2010.

The explosion in US production followed a long period where oil was priced at $100+ a barrel. That meant it suddenly became possible to extract oil when it had previously been too expensive to do so – fracking was viable.

Even with the press attention fracking’s had in recent years, it’s not a new technique. Fracking as we know it today has been in the pipeline since at least the late ‘90s. Water, sand and chemicals are pumped underground at very high pressures. This cracks the surrounding rocks, releasing the oil and gas trapped within.

$100 a barrel made this technique financially sound on a huge scale. As the graph below shows, the number of drilling rigs active in the US (as measured by the Baker Hughes Index) climbed throughout the $100 a barrel period. With more oil rigs drilling, production soared.

Oil Price vs US Oil Rigs

Source: Thomson Reuters Eikon 20/07/18

So what changed in 2014?

Greater supply should have pushed prices down, but the extra oil was being vacuumed up by growing demand in Asia. Then there was a big slowdown in growth in the big emerging economies in mid-2014. Suddenly the demand for all that extra oil wasn’t there.

Oil prices started to drift.

OPEC sits it out.

Even with the growth in global oil production Saudi Arabia, the leading member of oil cartel OPEC (the Organisation of Petroleum Exporting Countries), decided to leave its output unchanged.

This is a change from recent history when OPEC has reduced output in times of low demand to keep market prices high. Exactly why that decision was made isn’t clear, but one of the better arguments is that Saudi Arabia was looking to protect its market share from the new US rivals.

Saudi Arabia’s average cost of production is thought to be less than $10 a barrel. It can weather a spell of low prices. Saudi’s willingness to see low oil prices can be seen as an attempt to throttle a potentially dangerous competitor before it got comfortable.

Put together increased production in the US, lower demand in Asia and OPEC’s willingness to see prices fall, and you’ve got a recipe for an oil price crash of epic proportions. And the market delivered.

Where are we now?

By early 2016 oil prices had sunk below $30 a barrel, less than the re-sale value of the drum it would come in. But with oil cheaper than at any time since the early 2000s, demand started to pick up. By the end of the year OPEC had agreed to cut production and we’ve seen a steady recovery ever since.

Oil’s spent 2018 trading between $60 and $80 a barrel.

Oil price ($/barrel)

Source: Thomson Reuters Eikon 17/07/18

What does the future hold for oil prices?

Despite the relative stability of the oil price, the outlook’s not clear at the moment.

On the one hand oil supply’s restricted. International and domestic tensions put a dent in output from Iran and Venezuela, who are both major exporters. OPEC’s also kept a lid on production. That should boost prices.

On the other, the resurgent US shale players are firing up the oil rigs again, while the threat of a global trade war has a negative impact on global oil demand. Neither’s good news for the global oil price.

But the most interesting dynamic could be the threat of ‘peak oil’.

The peak oil problem

Not so long ago ‘peak oil’ meant the world running out of oil. Today it’s more to do with the idea that we’re close to peak demand for oil and oil products.

30 years ago the contribution of non-hydro renewable energy to global electricity production was insignificant. Today it’s 8.4% and growing fast. The introduction of electric cars even threatens to unseat oil from its dominant position in transport.

The effect of an increase in renewables is being enhanced by efforts to increase energy efficiency. US light duty vehicles (including cars and vans) have improved their fuel economy from 14.9 miles per gallon in 1980 to 25.2 in 2017, for example.

Together these trends mean many industry commentators think demand will slow in the years ahead. BP estimates that peak global oil demand will be somewhere in the second half of the 2030s. A long term decline in demand doesn’t bode well for prices.

The threat of peak oil might explain why Saudi Arabia was suddenly willing to sell its oil at a much lower price. Better to sell your oil cheap than leave it in the ground, only for reduced demand to make it worthless.

But where does that leave oil and gas companies?

Investing in oil - majors and minors

Nicholas Hyett

Equity Analyst

Investing in oil

The 2014 crash caught oil companies by surprise.

The sector went into the crash loaded up with debt. You can still see the scars it left on the industry. Between them, BP and Shell have £1 in every £7 of debt at UK listed companies.

A quick fix for mending a broken balance sheet is to cut spending, and cost cutting’s been brutal. But with much of the heavy lifting done, how’s the sector doing now?

Progress at the majors

Cost of a crash

Oil majors produce millions of barrels of oil a day, and control billions of barrels of reserves. As well as pumping crude oil, lots operate further down the supply chain where they refine and sell oil products.

Normally, this should help majors ride out the ups and downs of the oil price. Production costs are low in comparison, and lower oil prices are actually good news for the refining side of the business, balancing out weakness on the production side.

But massive debt piles and scale of the oil collapse in 2014 offset those traditional strengths, made worse in Shell’s case by their commitment to buy BG which completed in 2016. The sudden fall in profits, with debts still to service, raised questions about the dividends’ sustainability, something the sector’s long been famous for.

Net debt ($bn)

*estimate. Source: Thomson Reuters Eikon

Dividend concerns were justified to a point. Both Shell and BP resorted to scrip dividends (paying dividends in shares instead of cash) to protect the balance sheet. Both scrip programmes are now over, having been wrapped up at the end of 2017.

Looking ahead

We think the oil majors are looking pretty well placed at the moment. A higher oil price and increasing production means profits are healthy once again. BP shareholders will be pleased to hear that costs associated with the Deepwater Horizon spill (all the way back in 2010) are finally falling.

Debt reduction might still have some way to run, but hefty yields of 5.4% at Shell and 5.3% at BP now look sustainable even at lower oil prices – though as ever no dividend is guaranteed.

The bigger concern is the possibility of a long term slide in oil demand – the so called 'peak oil' problem. If oil demand falls, oil majors’ reserves of deep sea oil could become too expensive to extract, leaving them with billions of barrels of essentially worthless oil.

The industry hasn’t stood still on the issue though. Both Shell and BP have upped spending in renewable technologies. Shell’s committed to spending an extra $1-$2bn a year, and BP recently bought the biggest electric car charging business in the UK.

BP share price, charts and research

Royal Dutch Shell share price, charts and research

Missed the minors

Even harder hit than the oil majors were the smaller oil groups with just a handful of oil fields, often in the early stages of development.

A lot of these groups had spent heavily to develop their fields. When the crash came, large debt piles and little or no production meant some were left fighting just to exist.

Several rights issues later, the likes of Tullow Oil, Premier Oil and Gulf Keystone no longer look like they’re facing oblivion. A higher oil price, and increased production from more mature fields mean the Armageddon scenarios have been pushed off the table.

Share prices have bounced as a result. But with the oil price already more than three times what it was in the depths of the crash, dramatic further increases look unlikely. We’re now in the long hard slog of debt repayments, and that means dividends from this part of the market look some way off.

These smaller names are a higher-risk play on the oil price. If it marches up a lot they’ll benefit, but if the current strength fades, it’ll be the minors who’ll be among those hit the hardest.

Tullow Oil share price, charts and research

Premier Oil share price, charts and research

Gulf Keystone Petroleum share price, charts and research

Flee E&P

Companies that focus on discovering new oil fields are known as Exploration and Production, or E&P, companies. They’re often small, focusing on oil fields in difficult environments – from Alaska to the Sahara.

Discovering a huge new oil field can be rewarding, but chances of success are slim to say the least. So these types of investments are very high risk.

Unless you’re an expert in the geology of the region in question, you probably won’t be better placed to judge an E&P company than the wider market. When an investment’s a black and white outcome like that, it’s not much different to a roulette wheel. Investors should probably steer clear.

A higher oil price would increase the value of any oil that explorers do uncover. So at least the pot of gold at the end of the rainbow would be a bit bigger in that scenario.

Where to invest in oil

Given the uncertainty about the oil price, we think majors are the place to be at the moment for those looking to invest in oil. Oil demand is unlikely to dry up altogether, and years of expertise in energy markets could give the big players a head start over smaller renewable groups.

In the short term, the combination of lower debt and rising profits means there’s enough cash there to invest in the future, while still rewarding shareholders with dividends. In a rocky sector, that shouldn’t be ignored.

But during a shakeup, it can pay to look outside the usual candidates.

Investing in oil - the shakeup

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. 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.

Nicholas Hyett

Equity Analyst

Looking off the beaten track

Fundamental changes to supply and demand are transforming the oil sector. While oil’s role as a key input for plastics, lubricants and many other products means demand will probably never subside entirely, shakeups like this always create winners and losers.

And the big names aren’t always the best placed to benefit. A look off the beaten track could potentially be rewarding.

Pioneer Natural Resources - frack to the future

There are some new oil and gas giants on the scene following the fracking revolution – among the biggest is Pioneer Natural Resources with a total market value of $31.5bn.

In 2017 Pioneer produced around 272,000 barrels of oil equivalent a day (boepd). Its flagship wells, in the Texan Permian basin, produce at an average cost of around $19 a barrel. Production here combined with the more expensive wells means the company thinks that, as a whole, it’ll be breaking even at around $50 a barrel by 2020.

All that makes Pioneer sound like sure thing, but even with the low cost of production the group still posted some dramatic operating losses when the oil price collapsed, mainly because of huge write-downs in the value of its oil assets.

Weak cash flows left shareholders and debt markets to make up the gap. In other words, the company has been dependent on the goodwill of its shareholders to stay in business.

But that could be about to change. In 2017 operating cash flows improved and the group even managed to meaningfully reduce debt.

Recent production numbers have been towards the top of what the company expected. Pioneer thinks they’ll start production from between 250 and 275 wells during the year.

That’s one of the things we like about shale. It’s a very responsive business. Unlike deep sea oil fields that take decades and billions of dollars to bring up to speed – shale rigs can be out and drilling in no time. Add that to Pioneer’s high quality assets, and the mix could be potent, though not without risk.

Pioneer Natural Resources share price, charts and research

Petrofac - riding a recovery?

One of the side effects of slowing demand and lower prices has been oil companies making dramatic cuts to investment budgets. Global investment in upstream (oil and gas exploration and production) has fallen a lot.

World upstream oil and gas investments ($bn)

Source: US Energy Information Administration

That’s not good news for oil and gas engineers. Fewer new oil wells being drilled mean less new business to be done. Petrofac, one of the UK’s leading oil and gas engineers has seen its order book fall from $18.9bn in 2014 to just $9.7bn. Share prices across the industry have fallen as a result.

The collapse in capital expenditure can’t continue forever though. Global oil production is running at almost 100 million boepd, drawing on reserves that will need to be replaced. We’ve already seen the early signs of a recovery, albeit a quiet one.

There are a few reasons we think Petrofac could be an interesting but higher-risk play if spending in the sector increases.

The group’s been pulling back from more marginal activities to focus on its core operations. These are largely in the Middle East and North Africa, regions where the cost of extracting oil is very low. That should mean development activity holds up well in all but the worst conditions.

Petrofac’s enjoyed a run of contract wins lately – and not only in the Middle East. Revenues and profits are expected to continue sinking this year and next, but analysts are expecting to see a recovery from there. Contracts installing offshore windfarms mean the group even has a foot in the door to the renewables sector.

The shares currently trade on a PE Ratio of 9.1, some way below the longer-term average, and offer a prospective dividend yield of just over 5%. There’s significant upside on offer if the group can deliver the expected improvements in profits.

But lower spending by oil and gas groups isn’t the only cloud hanging over Petrofac. The company and its CEO are under investigation by the Serious Fraud Office over its relationship with a company that provided local consultancy services, mainly in Kazakhstan, between 2002 and 2009.

The investigation could mean both risk and opportunity. If found guilty the fine could be weighty. If not, the gloom over the stock could lift, taking the share price with it.

Petrofac’s the classic recovery play. For those with a long-term investment horizon that could make it attractive, though there is extra risk involved.

Petrofac Natural Resources share price, charts and research

Vestas - wind in the sails

Oil majors are increasingly taking large stakes in wind power, as an investment to shelter from an oil-free future. But for those who think that’s too little too late, there’s always the option of going straight for renewable energy.

It’s proven to be an unpredictable sector in the past, partly due to relying heavily on government support, and partly because as a new and emerging industry, technology can change rapidly. But wind generation’s one of the better-established technologies.

Danish firm Vestas is the world’s leading designer, manufacturer and installer of wind farms. The company’s installed 17% of global wind capacity, more than anyone else. That’s around 64,000 turbines, including 1,900 in the UK.

As well as building wind farms, the group delivers ongoing services to its own, and third party, turbines. That includes maintenance works as well as optimising performance.

Although services only make up 15.3% of revenues at the moment, the division is growing steadily. Growth is expected to be at least 10% a year in the near future.

Vestas Revenue (€bn)

*estimate. Past performance isn’t a guide to the future. Source: Thomson Reuters Eikon, 09/07/18

Across the wider group, Vestas aims to grow revenue ahead of the market over the long term, with operating margins of 10% or more. A steadily growing contribution from services should help to reduce the group’s reliance on the commissioning of expensive new wind farms over time – helping to make revenues more reliable.

Unlike many emerging technology companies, Vestas’ size and relative maturity means it can afford to pay a dividend. At an estimated 2.3% yield this year, it’s not a small one. A PE ratio of 13.4 times means the shares aren’t highly rated either.

That partly reflects how mature the wind sector is. Vestas thinks the market will become unsupported in the near future, driving more competition and consolidation. The group’s already seeing pressure on turbine prices, with negative consequences for margins in the more dominant power solutions business.

There could be a rocky couple of years ahead then.

Long term we think Vestas’ dominant position, in a sector that will be a key contributor to energy generation, should stand it in good stead.

Vestas share price, charts and research

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. 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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