True, Hargreaves’ share price has been more volatile than the oil price and on some occasions in the past 10 years it gave the band a good tug. But, statistically speaking, the band would not break and for the past five years – barring one period in 2012 – there has been a spooky symmetry between the two.
This prompts the thought: is it worth buying shares in Hargreaves as a play on the recovery in the oil price? The attraction is that, if you did this via Hargreaves shares, not only do you get the oil-price revival with gearing, you get something that speculating via an exchange-traded commodity fund won’t deliver – a 5 per cent-plus dividend yield.
Granted, that question assumes that the oil price – now back to $60, as measured by the spot price for Brent crude – will recover. As to its short-term movements, I have little opinion. My previous mutterings on this subject were also around the current level but as the price headed south (Bearbull, 9 January 2015). Then I suggested that, in the coming months, the price was as likely to hit $20 as $100. Given, say, a warm spring and good news coming from the Middle East, that view might regain its currency. Intuitively, however – and thinking longer term – we just ‘know’ that oil’s equilibrium price will be somewhere between the present one and $100 (obviously with the potential for spells overshooting on both the upside and downside). If you accept that proposition, then it is okay for a patient, risk-tolerant player to deal in Hargreaves.
Except that, before committing capital, there are stock-specific factors to be weighed up. First, and most obvious, is the state of the UK coal industry, which is vital to Hargreaves as a vertically-integrated coal supplier, mostly to UK power generators. Current trading is lousy as Hargreaves’ first-half results for 2014-15 showed (see IC, 20 February). Depressed demand for coal, linked to the falling price of oil, hacked away at coal prices, while a mild winter in the UK has depressed sales volumes. In Hargreaves’ production division, surface mining of thermal coal was loss-making; in its distribution division, revenues dropped a third to £332m as UK power stations cut their coal burn.
Predictably, Hargreaves’ bosses are defiant. They point out that “new power-generation capacity to replace existing coal capacity remains behind schedule” and that there is “increasing uncertainty around regulation and government policy”. Therefore they conclude that coal-fired electricity generation will “continue to have a significant role to play in the years to come”.
True, some sort of middle-way scenario seems the best guess for coal-fired power. In theory, power generation from so-called ‘renewable’ sources should pose an existential threat. As it is, in perverse ways it encourages coal-burning plant. That’s thanks to the colossal mess of the EU’s energy policies, which have become a racket serving the interests of an unholy alliance of ‘greens’, equipment suppliers, power generators and governments. The effect is to extract rents from consumers in a manner that produces the maximum amount of market distortion and an increase in CO2 emissions. So, for example, low prices for coal in Europe combined with too many emissions permits in the EU’s emissions-trading scheme encourage generators to burn coal. Worse, huge subsidies for generating power via ‘biomass’ (ie, wood) stimulates coal consumption since coal-fired power stations easily convert to run on a mix of coal and wood.
One day the cost of that scam may be unsustainable. Meanwhile, Hargreaves appears to be as much a beneficiary as a victim. Yet its share price – at 500p it is 60 per cent below its all-time high – makes it out to be an unequivocal loser. And therein lies the possible investment opportunity. Look at it this way: last year Hargreaves made trading profits of £51m and this year City analysts reckon that figure will fall to around £30m. But it could crumple to just £19m, stay there and still be enough to justify the current share price. Or it could, if you assume a continuation of Hargreaves’ current capital structure, produce an annuity comprising notional ‘net operating profits after tax’ of £15.2m, a weighted cost of capital of 7.4 per cent and surplus cash of £13.5m.
True, if trading stays very bad, Hargreaves might test £19m of trading profit in 2015-16 or beyond. Currently there is little telling whether or not that’s likely, though the company’s bosses are bravely increasing the dividend.
Actually, it’s too early for me to make an investment decision. I have more work with valuation models for Hargreaves, then there is the matter of checking out another possibility from the Bearbull ‘Instant Income Fund’ (see Bearbull, 20 February 2015) – oil services provider Petrofac (PFC), whose 2014 results are out this week. The progress of both will be strongly linked to the oil price, but I’ll only want one bet on oil in the Bearbull Income Portfolio so only one can pass muster. To be continued next week.
