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FTSE 350: Big oil in the balance

Strong cash generation in 2019 should not disguise the growing threats to the sector
January 24, 2019

What would true 'balance' in the oil and gas market look like? Ask an industry executive or a state oil minister, and they might say '$65 a barrel'; high enough to incentivise new projects and exploration, but low enough to prevent a flood of supply. Ask a US shale oil driller, and they might see balance as maximising production while keeping financiers onside. Ask a climate scientist, and they might view balance in environmental terms, and the need to abandon all exploration work, manage production declines, and rapidly pivot to an electrified transport system and a grid powered by renewables, where the levelised cost of energy continues to fall – and in many cases now beats – fossil fuels.

The problem with oil and gas stocks is the opacity of their near-term fortunes. It’s fruitless to predict the immediate trajectory for prices, but it’s safe to say that Brent crude at $65 will fail to balance the market. No matter how much various cartels try to manipulate prices, the world now faces a “relentless growth in non-Opec supply”, in the words of the International Energy Agency.

Added to this are the growing threats to demand. In 2019, investors will be unlikely to experience profound disruption to the energy market, but the sector is like the proverbial frog in a slowly-boiling pot. As Stanford University professor Mark Jacobson has shown, fossil fuels in all corners of the world can now be replaced by technologies whose costs and performance continue to improve every year. This has already begun with the globe’s electric power needs, and will spread into transportation once electric vehicles come to dominate sales of new cars in the next five years. In turn, these come with serious implications for gas and oil demand.

Then there is climate change, and rapidly shifting investor attitudes towards the sector, typified by a gradual swing towards divestment and pressure on corporate boards. Last month, global investors with $32 trillion (£24.8 trillion) of assets under management urged governments to step up their action against climate change, or risk economic impacts at least "three or four times the scale of the 2008 global financial crisis".

Put together, a lot is stacked against the sector. Uncertainty isn’t unique to oil and gas investing, but it’s a worry for a highly capital-intensive industry that invests on multi-decade horizons. Consequently, there’s reason to believe the cash-generating power of Royal Dutch Shell (RDSB) and BP (BP.) in 2019 could prove a mirage.

This is especially important for those investors who are principally in the sector for the supermajors’ dividends. Excluding the effect of share buybacks, both stocks currently offer a 6 per cent yield, which in both cases will account for more than three-quarters of free cash flow for 2019, based on HSBC forecasts.

Are those yields worryingly high, or not high enough? At the current rate, and assuming no dividends are reinvested, the supermajors’ returns will repay their initial investment after 17 years, a bond-like return implying a benign period of trading ahead. Then again, at least BP and Shell have the balance sheets to easily afford dividends, unlike Tullow Oil (TLW) and Premier Oil (PMO) – both of which are typical of the chronically over-levered stocks further down the food chain.

Consequently, our house view on the sector is increasingly bearish. Ours may still be a fossil fuel economy, but the pace of regulatory, investor and technological change within energy markets suggests negligent strategic thinking is rife.

 

NamePrice (p)Market cap (£m)12-month change (%)Trailing PEForward PEDividend Yield (%)Last IC View
BP511103,558.2-1.0311.211.75.94Sell, 525p, 22 Nov 2018
Cairn Energy179.81,059.92-17.348.4150Buy, 222p, 11 Sep 2018
Energean Oil & Gas622952.61 23.219.20Hold, 532p, 13 Sep 2018
Premier Oil69.9571.13-26.2352.90Hold, 71p, 14 Jan 2019
Royal Dutch Shell A 2,305102,841.4-8.6611.310.36.11Buy, 2,706p, 4 Oct 2018
Royal Dutch Shell B2,32286,970.19-9.611.410.46.13Buy, 2,706p, 4 Oct 2018
Tullow Oil2012,800.82-9.8310.69.60Sell, 221p, 8 Nov 2018