Equities: Which Way Are Oil Stocks Going?

The energy sector has clearly underperformed in recent months, shedding 7% and 4% in the US and Europe respectively since mid-February. After the stellar performance in 2016, oil stocks started to suffer from a less favourable environment, fuelled by concerns over the ongoing reflation trade and another fall in oil prices.

The big question is whether industry players have the capacity to generate cash flow. In the context of a dramatic fall in oil prices in 2014 and 2015 (from $100 to $25 per barrel), oil groups needed to adapt their strategy in a bid to reassure investors of their ability to maintain their dividend. As a result, cost controls and overhauled investment plans became their watchwords. Thanks to these measures and the return of the barrel price to $50, cash flows improved, dividend concerns faded and oil stocks strongly rebounded on the markets.

Today, investors are alarmed at the fresh decline in black gold. Firstly, oil production in the US has been accelerating. At $50, unconventional oil wells (shale oil) are back in profit and coming back on stream in large numbers. Secondly, the markets are considering the viability of the production deal signed by OPEC member countries at the end of 2016. According to the International Energy Agency (IEA), production has increased. A rise in production could jeopardise a rapid rebalancing between oil supply and demand.

However, the long-awaited rebalancing in supply and demand could occur within the next 12 months:
 

1. Demand should pick up thanks to a more favourable economic environment. The IEA forecasts an increase of 1.4 million barrels per day in 2017.
2. The OPEC agreement, signed between members and non-members at the end of 2016, will be maintained. Oil inventories will take time to run low before the effects of the agreement feed through. But the parties to the agreement will have no choice but to maintain it.

Against this new backdrop, without hoping for a strong recovery in the barrel price, we expect oil to trade within the $50-60/barrel range over the next 12 months. Currently penalised by the return of the barrel price to $50, the oil majors will benefit from the rise in the barrel price. Moreover, they are trading at fair valuation levels (14x P/E ratio in Europe) and still offer an attractive dividend.