The changing face of the oil industry

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Invesco Perpetual’s Stephen Anness and Andrew Hall discuss the potential for capital gains in the oil sector over the longer term

We continue to allocate a good deal of our research time to the oil sector. The reasons are simple. We see a sector that trades at a depressed valuation in both absolute and relative terms at a time when we see tangible signs of industry change. This combination tends to be a fruitful backdrop for investment opportunities. We think that the changes that are currently being implemented will in time lead to improved returns on capital and in turn a higher sector valuation.

We talk consistently of the importance of being contrarian as being a pre-requisite for long-term outperformance. Buying oil stocks right now feels contrarian. If we are correct in our assessment of the industry’s prospect, we see the potential for capital gains in this sector over the longer term. To be clear, this is not a macro call based on an oil price assumption. It is a view that industry returns have fallen well below historical norms and that companies are beginning to take action to improve returns. Indeed, although company behaviour started to change before the oil price did, a lower oil price is perversely quite helpful to management teams which need to rein in operating and capital expenditures. Given the self-help opportunities available to management teams in the sector, we believe it is certainly possible that some of the major oil producers can be more profitable at a lower oil price (clearly subject to some limits).

 

This month the investment team travelled to Stavanger in Norway to meet a number of senior managers from Statoil. We also met the CFO of BP before travelling to the US to meet a number of the world’s largest oil field services companies in Houston. These meetings help us to gain a deeper understanding of the issues that face the industry and to gauge the industry’s progress on tackling them. There has been a very consistent theme from these meetings. Management teams appear to be increasingly focused on cost and capital discipline, process simplification and cash generation. It may sound counter-intuitive but the fall in the oil price has actually served to increase our conviction in our industry-change thesis.

In short, investors are very distrustful of management teams’ ability to allocate capital in a profitable manner in this sector. As capital intensity has risen, the valuation of the sector has fallen. We would argue there is good reason for this. Historically the industry has been poor at timing capital investment. Typically the greatest level of capital investment takes place after the oil price has risen and vice versa. With this in mind it’s understandable that the stock market has been dubious about the quantum and timing of the capital investment the industry has made.

We are sure that some management teams will be more adept at it than others, but in aggregate we find it difficult to believe that the industry will be able to sustainably improve in this regard over the very long term.

However, given the current valuation of some companies we don’t need to believe that it will. What we are arguing is that oil industry returns are cyclical and that we currently find ourselves at or around a cyclical low-point for industry return on capital employed (ROCE). This is happening at a time when management teams are very focused on improving their returns. We expect to see a reduction in capital intensity combined with improved cost efficiency driving an improvement in ROCE.

It’s clear from the chart that Shell’s return on invested capital (ROIC) is cyclical and that Shell’s share price seems to broadly track its ROIC. Currently the enterprise value/information coefficient (EV/IC) of Shell is near 2008/09 lows. This is broadly reflected across the industry. If we are right in our assessment that industry ROIC is set to recover, we believe it is likely that this will be rewarded with a higher valuation multiple. That’s why our analysis and our meetings with management have been focused on understanding the potential to improve processes, drive simplification, optimise capital and cost efficiency and thus improve returns.

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