After close to a decade of underperformance there are strong indications that 2018 could finally be the turnaround year for the world’s major energy companies. In this post, I provide some reasons why this could be:
The synchronised global growth currently being seen across developed and emerging markets should provide support for oil demand. Meanwhile, the Energy sector itself remains under-weight in typical investment portfolios, after years of underperformance. Some analysts believe the Energy investment cycle has now begun a new phase after a multi-year consolidation, which is also supportive of greater profitability for the Energy majors as opposed to those smaller producers and U.S. shale companies who have struggled with capital funding.
U.S. Energy Equities Performance Gap at Multi-Decade highs
The underperformance of the energy sector compared to the rise in the S&P 500 has now opened up the widest divergence in 17 years, with U.S. listed energy companies being the biggest detractor from the S&P 500 in 2017.
Our own Global Energy Companies ETF (ASX: FUEL) underperformed the S&P 500 by over 19% in the 2017 year, and also ended the year out of step with the spot price of WTI crude by just over -8%. However, from Q4 2017 there was an upward change in the trend, with U.S. energy earnings revisions in particular up 24.3% since the beginning of Q4 2017, and, according to a recent report from Morgan Stanley, the U.S. energy sector is projected to see +130% YoY EPS growth for the quarter.
Source: Bloomberg. Past performance is not indicative of future performance.
Positive outlook for Big Oil: Consolidation and Corporate Returns
In December 2017, Goldman Sachs research discussed the evolution of the energy investment cycle of the last 10-15 years and the new phase of industry consolidation. They identified the following key points:
- The investment upcycle of 2001-2014 saw the energy sector suffer excessive fragmentation. In this environment, high oil prices and easy access to capital attracted waves of new entrants – with heavy investment in exploration and production and extreme prices for undeveloped acreages
- This was a terrible time for the profitability of oil majors as new entrants (a) cut into their market share and (b) drove up the cost of production
It is their view that we’re now entering a new phase as the sector is consolidating and has reset itself to operate at a lower oil price:
- Smaller competitors who entered the market are now finding it difficult to fund themselves through bank lending – with banks increasingly reluctant to lend against oil reserves
- ‘Big Oil’ once again dominated the complex long-lead time mega projects – with the 7 largest companies accounting for 90% of sanctioned projects in the last three years. In the decade prior, investments in this scale of project were divided across 50 companies
- 3 years of successful cost cutting and focus on improving the economics of conventional deep water projects, combined with decreased competition, has improved free cash flow and created the opportunity for a revival in profitability
- There is now scope for this to be used to enhance company value and increase focus on shareholder returns through dividends and buybacks – rather than overspending on cash flow in a competition for growth.
Question marks over growth and sustainability of US Shale
Supply growth of U.S. shale has been a key concern for investors around the outlook for oil prices over recent years.
However, like the broader energy market mentioned above, difficult conditions faced by the industry over the last two years has seen exploration activity curtailed.
U.S. shale in particular requires continued investment to maintain production levels – where conventional oil wells typically produce over 15 to 30 years. Production from shale wells peaks within a few months after beginning and is estimated to decrease by ~75% after only one year. This means that in order to keep up with production shale producers need to constantly drill new wells.
With improved economies for larger conventional projects, U.S. shale producers are not only losing competitiveness to Big Oil but are also have their own unique funding issues:
- The high yield market has been the traditional driver of shale activity – but lower prices and higher debt levels have seen investment in non-conventional exploration and production in the US become less attractive to investors and access to capital has become particularly difficult for many smaller US companies – which is likely to become increasingly difficult against a rising rate environment.
- Any reserve based bank lending to any business activities related to shale and/or tar sands has recently been blacklisted by BNP Paribas – historically one of the world’s largest lenders to the energy industry.
Record compliance with self-imposed production cuts by OPEC members has evidently had the desired effect, as crude inventories continue to decline and the oil price stabilises. While risk of a return to the levels of production growth from U.S. shale producers of recent years appears to be mitigated by limitations on the access to capital.
What this means is that, should OPEC remain disciplined and shale production growth constrained, global energy markets could return to higher cost sources of supply, such as conventional offshore production, which are once again the domain of Big Oil.
With Energy one of the under-held sectors in investment portfolios, improvements in free cash flow and corporate returns, which have lagged other sectors, could ultimately see investors return to the sector. While any ongoing emerging market expansion, along with the current synchronised growth in developed markets, should provide support for oil demand.
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