Equity Markets: Are Energy Shares A Value Trap Or A Buy Opportunity?

Oil shares have underperformed year-to-date, penalised by the freefall in the price of the barrel. Between January and June, the Brent barrel price shed 20%, from USD 55 to USD 45. Over the past few months, investors have had growing doubts over whether a rebalancing between supply and demand in oil markets is possible.

At the end of 2016, an agreement to reduce production (1) signed between OPEC members and Russia pointed to a cut in supply and potentially a rapid fall in overcapacity. However, since February, investors have been less and less convinced of such an outcome. Oil production and crude oil inventories remain high. As nothing has really materialised, the announced rebalancing is becoming more hypothetical.  Investors now consider OPEC’s strategy as a failure.

Several unfavourable factors have penalised oil recently. Firstly, Libya and Nigeria—which were exempt from quotas in the last OPEC agreements—have resumed production. Although their return to the market was expected, the production increases in these two countries are preventing a rebound in the barrel price.  Secondly, the summer season, characterised by increased travel in the US (“driving season”), is slow to get underway. Finally, with the overproduction in unconventional (shale) oil in the US, the global supply remains abundant. US producers can still produce at low costs thanks to technical advance. Moreover, they have the capacity to rapidly revive their activity as soon as the barrel oil price rises again. US oil companies increase their production whenever there is a rebound in oil prices, dashing any hopes of a substantial recovery. On the other hand, a floor level seems to have been established: the very low price is creating productivity problems for certain American drilling sites. With these disruptive factors across the sector, the barrel price has been fluctuating between USD 45 and USD 60 for several quarters.

However, we remain convinced that the oil supply-demand rebalancing will take place in the coming 12 months. The process will certainly be slow, but we note the following:

 

1. OPEC has no other choice but to impose a reduction in supply. The determination of Saudi Arabia and Russia is firmer than the market estimates. The terms of the OPEC accord were confirmed at the end of May. If the latter are respected properly, we may rapidly enter a period of a production shortfall, and in turn, a reduction in global oil inventories.
2. The ongoing economic recovery will continue to underpin the demand for oil. Our scenario is a more robust economic growth in 2017. The market underestimates this positive effect. Demand should also be supported by seasonal effects (driving season in the US, warmer weather in Asia and the Middle East).
3. The barrel of oil at USD 45-50 is creating profitability problems at US drilling sites. Except in the event of new technical progress or tax support measures by the US authorities, US shale oil producers are near breakeven, even if, admittedly, this level is not clearly defined. This will lead to a decline in the number of drilling sites, and therefore production cuts in the US.
    

Consequently, in our view, the barrel price should rise, but probably not above USD 60. If the barrel of oil climbs too high in the second half of 2017, oil shares will be a buy opportunity. They are currently trading at low valuation levels: below 14x price/earnings in Europe, i.e. well below average. Fears of dividend cuts (as in 2015) following the collapse of the barrel price to nearly USD 25, seem overdone. In 2015-2016, most sector players had succeeded in securing their dividend by cancelling major investment projects. Consequently, integrated oil companies should deliver solid cash flows, supported by a good control of investment spending and a rebound in the barrel price in the second half of the year.

Moreover, investors have not punished integrated oil companies in the same way that has affected the barrel price over the past five months. On the contrary, integrated oil companies have been rather resilient. Indeed, they offer an attractive diversification (upstream and downstream activities) which is reducing the risk. In addition, they offer high dividends (7% in Europe). They have only lost ground since June and are today oversold. Therefore a pessimist scenario for oil appears to be largely priced in by the market.

However, it is still too early to expect a renewed interest in oil service companies. Their activity depends on the investment plans of oil majors. As projects have been postponed in recent years, the needs are great, but most sector players remain nervous. A recovery in investment spending is therefore unlikely in the short term and we consider that the absence of a spectacular rebound in the barrel of oil is jeopardising the chances of the industry outperforming.