Oil prices are notoriously volatile, but right now they are pretty low, even as OPEC+ cuts supply. Brent crude started 2023 at $79 a barrel and while at its current level of $76 per barrel (as of 11 December) does not sound like it has travelled much, it was as high as $94 in September.
Good luck finding a fund manager who will stick his finger in the air and predict where oil prices are going next (and rightly so), even those invested in the oil majors. But we can take some things away from the three-month low in Brent.
Clearly lower oil prices are good news for a number of industries, think airlines and shipping, for example. It’s also welcome news for countries who are big importers, such as India. From a macro view, lower oil prices are also helpful for central bankers trying to control inflation and bring it back to target. This also increases confidence in the bond market that we have hit peak interest rates.
For energy producers, though, a natural response would be to assume lower oil prices are a big challenge. But this doesn’t capture the nuances of the investment case for the energy sector, which we think is still strong.
Ed Legget, fund manager at Artemis Fund Managers, says while oil prices are currently lower, a better indicator for the health of the sector is oil producers’ breakeven point' – the point at which total cost and total revenue are equal.
“The breakeven point for each barrel of production is going down for these oil companies,” says Legett, meaning they have to sell fewer barrels to cover their cost.
“A decade ago some of the projects the big oil companies would have done would have had a $60 a barrel cash flow break even. Today, BP and Shell’s portfolios are in the mid $30s, early $40s,” he points out.
So yes, the oil price is lower currently, but the breakeven point is a lot lower, supporting Leggett's view that “fundamentally, the economics of the business for a given oil price are better than they were historically”.
Legget says BP and Shell also have an attractive high free cash flow generation at present (the cash a company generates after cash outflows for its operations and maintaining its capital assets).
“With oil prices at $70-$90 a barrel, BP and Shell are on free cash yields of 10-15%. That cash flow ultimately will come back to us in dividends and share buybacks, or will be invested into growing the business,” Legget points out.
What about the energy transition? Legget is convinced by the oil companies role in that too. “As part of the energy transition, the capital discipline in the sector is just materially better than it was,” he says.
This is because oil companies have committed to reducing scope one and two emissions, and alongside that UK oil producers have committed to reduce production significantly from pre-Covid levels.
These actions mean the capital oil companies are investing in the sector is only going into the highest-returning projects, the best projects they can find, “hence we see the sector is making a higher return on capital for a given oil price than it has done in the past,” Legget says.
GQG Partners Emerging Markets Equity fund has around a fifth of its assets in energy, including in Brazil’s Petrobras and France’s Total. Manager Rajiv Jain is overweight the sector, due to what he considers to be a dearth of supply.
A lack of capital spending on exploration since the end of 2015, coupled with what he considers to be “real discipline” in production growth by the larger energy companies and OPEC+, is likely to put a sturdy floor under crude oil prices in the medium term.
Also, the release of strategic petroleum reserves around the world to address higher prices in 2022 has ended. As these reserves are likely to be restocked during the next 12-18 months, Jain expects this to act as a source of incremental demand.
Perhaps more importantly, the names he owns are expected to pay “meaningful” dividends, which may cushion some of the potential volatility in their stock prices should global economic activity start to look even more shaky.
Arguably the most solid (and obvious) investment case for the energy sector, however, regardless of short-term oil prices, is that we still have an insatiable need for these products.
As Richard Knight, manager of the Allianz UK Listed Opportunities fund, which has 12.5% in energy, says, “with relatively predictable long-term demand, we believe the balance will remain favourable for the producers into the medium term”.
The fact is, almost everything we use from iPads to Volkswagens, takes energy of some kind to run. Even as fossil fuel is phased out, the development of alternatives is still being led by traditional fuel-producing companies.
Economic growth in emerging markets; increasing emphasis on energy security; and the difficulty of decarbonising some sectors of the economy quickly; are all supportive for demand, Knight adds, “whereas investment in new supply is only just picking up from levels that don’t adequately replace the natural decline in production as wells run dry”.
So while investors may panic at headline oil price falls, with strong free cash flow, disciplined capital investment, good dividends, ongoing demand, and the potential for stable returns from investment in renewables, the investment case for the energy sector remains robust.
Good places to look for strong exposure to some of the oil majors would be the likes of UK equity income vehicles, such as the City of London Investment Trust and the Rathbone Income fund, where the likes of BP and Shell are prominent in their top 10 holdings.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above should not be taken as investment advice.