Will oil be back?

OPEC is ending 2019 where it ended 2018: on the back foot, trying to support the price of oil with production cuts pushed through in conjunction with Russia and other countries which are not members of the cartel. The extra reduction, which takes the total to 1.7 million barrels of oil a day, is giving the price of crude a little lift but not enough to really give succour to shares in oil explorers and producers. Looking at the S&P Global 1200 index, the energy sector is the worst performer among the 11 major industrial groupings that make up the benchmark and the only one that has failed to provide a double-digit percentage total return in sterling terms.

Energy is the worst performing global sector in 2019

Source: Refinitiv data, based on S&P Global 1200 indices. Total returns in sterling. Covers period 1 January to 11 December 2019.

The picture becomes even more stark when investors look at the weighting of the energy sector within global equity benchmarks. Looking at the MSCI World, energy is down to an index weighting of less than 5%, right down by its all-time lows. That means the energy constituents of the 1,650 member index have a combined market cap of $2.1 trillion – which is less than the current combined valuation of the two largest stocks, Apple and Microsoft:

Energy’s weighting in the MSCI World index is near its all-time lows

Source: MSCI

Advisers and clients with exposure to individual oil firms, specialist energy funds (be they active or passive) or geographic stock indices with a hefty exposure to oil companies (which would include the FTSE 100) must now decide whether the latest bout of oil stock underperformance is merely cyclical or the result of something more structural.

Cyclical issues

It is possible to argue that oil’s woes are merely cyclical. The MSCI energy sector is trading at the same level as it did in March 2005 and the actual oil price is barely changed from August of the same year in nominal terms. This may not be a coincidence. In inflation-adjusted terms, this means oil is cheaper still.

Oil and oil stocks are trading near 14-year lows

Source: Refinitiv data

The problem seems be one of supply, thanks to the boom in US shale oil production – which is now exceeding the equivalent of 9 million barrels a day, up from 1.5 million a decade ago.

Oil bulls will counter this by pointing out how the US shale boom is turning to bust. The HaynesBoone Oil Patch Bankruptcy Monitor reveals that 33 US oil and gas drillers have filed for bankruptcy so far in 2019, up from 28 in the whole of last year, thanks to the sector’s $100 billion in borrowing, which mean even a flat oil price is straining some balance sheets.

As a result, US shale oil output is up ‘just’ 13% year-on-year (or one million barrels a day), thanks in part to financial distress at some of the debt-funded shale drillers. There could be more pain to come and the chart shows how lower oil prices reined in US shale output in 2015–16.

US shale oil production growth is slowing

Source: US Energy Information Administration

Secular issues

It therefore could be argued that the best cure for low oil prices is low oil prices, as supply is squeezed out of the market in a normal cycle.

Whether an era of unprecedentedly cheap money, as a result of zero or negative interest rates (ZIRP or NIRP) as well as quantitative easing (QE) will allow enough bankruptcies is an open question. A stronger case for a secular stagnation or outright decline in oil price and oil stocks lies in the rise of alternative energy sources, relative to hydrocarbons.

This story is yet to play out, since oil demand continues to rise. According to data from the US Energy Information Administration, global annual oil consumption has fallen just five times since 1980 and only twice this century. On each occasion (1981–83 and 2008–09), the reason was a deep recession.

Global oil demand is still rising – at least for now

Source: US Energy Information Administration, BP World Energy Review

As such, the world is yet to wean itself away from crude but the Paris Climate Accord and other initiatives targeting carbon neutrality, let alone the rise of solar and wind power and electric vehicles, lead many to hope that the process will begin soon. If that is the case, then oil fields could become stranded assets, worth less than investors think – and asset write-downs by America’s Chevron and Spain’s Repsol mean this re-evaluation may already be happening.

A further secular theme to consider is the rise of Environmental, Social and Governance (ESG) issues on investor sentiment. It is possible that more and more investors will simply shun oil stocks on ethical grounds. This could hurt – the lower their share prices go, the lower their weighting in the headline indices and the more shares passive and tracker funds will sell as a result, in what could become a self-perpetuating trend.

Equally, contrarians could argue that passive (‘dumb’) money departing the sector before its economic use comes to an end will create a value opportunity for active (‘smart’) money to exploit. We shall see, but this is no academic issue for investors in the UK, since the energy sector is forecast to produce 16% of the FTSE 100’s profits in 2020 and pay 20% of its dividends.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.