AXA IM: Five reasons to take a look at junior energy stocks
The transition from traditional to alternative energy sources, is presenting opportunities in small and mid-cap (“junior”) energy players argues senior portfolio manager of the AXA WF Framlington Junior Energy Fund, Sebastien Lagarde:
- The recent drop in oil prices presents an opportunity to access the sector relatively cheaply
- Secular themes such as the boom in unconventional energy offer potential opportunities in small and mid-caps
- Unlike energy majors, junior energy companies don’t tend to have the issue of needing to renew their reserves
- Oil services and equipment companies – a way to potentially benefit from rising production costs
- Alternative energies offer a solution to energy supply and demand imbalances
“The recent drop in oil prices presents an opportunity to access the sector relatively cheaply. The drop is reflective of a temporary weakening in the global oil supply/demand dynamics, with slowing demand coming from big oil markets including China, and new supply coming from countries including Libya, Iraq and to a lesser extent the US. In addition, OPEC countries which normally act as a swing factor by cutting production when oil prices drop, have not reacted yet. However, OPEC countries like Iran will not be able to sustain their budgetary expenses if oil prices stay durably below $100. Therefore we believe this is a temporary experience, not reflective of the long term outlook, and an attractive opportunity. Besides, energy prices are likely to remain high as marginal production costs have been continuously creeping up for the exploitation of new resources, such as the oil sands in Alberta.
“Secular themes such as the boom in unconventional energy offer potential opportunities in small and mid-caps: The future for shale gas and oil still appears bright in North America and there is still plenty of room for production growth and cost reduction. As far as other countries are concerned, Europe, China and Argentina are often quoted as having large unconventional resources but there remain many question marks. For example, most international companies which entered Poland to develop new unconventional resources finally gave up as most of the projects proved to be uneconomic.
“Unlike energy majors, junior energy companies don’t tend to have the issue of needing to renew their reserves. In the case of a successful discovery, the leverage effect on the valuation of their assets can be huge. Taxation has little influence on their results as often their strategy consists of selling their producing assets before covering the exploration costs. This is if they haven’t already been bought-out by a major who views them as an easy way to maintain its level of reserves. Additionally, small and mid-caps’ exposure is often limited to a few oil fields, therefore these companies can exhibit discovery rates beyond the 25% probability validated by more than 100 years of statistics a characteristic less obvious for the majors as discovery success is diluted by the law of large numbers. The other side of the coin is that junior energy companies don’t have the same reserves to fall back on and can be susceptible to a greater risk of failure.
“Oil services and equipment companies are a way to potentially benefit from rising production costs and are therefore key holdings in our portfolio. On a shorter time horizon, North American companies involved in unconventional oil and gas production, offer, in our view, an attractive investment case as they benefit from strong production growth with declining costs (they are still on the learning curve for horizontal drilling and fracking). North America is the only region in the world where production costs are actually declining. AXA WF Framlington Junior Energy has a strong exposure to North American exploration and production companies, but also to equipment, services, and infrastructure companies involved in this revolution of the hydrocarbon industry.
“In the future, alternative energies look to be a clear way to balance supply and demand for energy. It is becoming harder to grow the supply of hydrocarbons and marginal production costs continue to increase year on year. Yet the demand for energy is growing 1-2% each year. In this environment, technology improvements and a progression along the learning curve have helped alternative energy resources become more competitive. An example of this at play is the price of photovoltaic panels, which has been decreasing every year.
“Our long-term view and deep conviction is that the junior energy sector offers great structural opportunities and is one of the best ways to benefit from high energy prices. We maintain a diverse exposure to the entire energy sector investing in both upstream (exploration and production) and downstream activities (refining, transportation and distribution), as well as equipment and services companies.”