Roberto Cominotto, investment manager at GAM comments on the impact of low oil prices on oil groups and explains why the energy sector nevertheless provides investment opportunities.
Second quarter results for the big integrated oil and gas groups – including Shell and BP – reveal the harsh impact of the collapse in the price of oil over the last 12 months. While some of the losses have been offset by higher margins in refining, the growing issue of overcapacity means that this safety net could be short lived. We fail to see any strong grounds to buy oil majors.
Large corporations such as Exxon, Shell, BP, ENI and Chevron are still struggling with significant structural problems. Between 2001 and 2014, during which time the price of oil rose from 40 USD to over 100 USD, these companies recorded decreasing production volumes and returns on capital employed subsequently halved from 20% to 10%. Mature or expensive assets remain the key problem, with liquefied natural gas in Australia and offshore oil, in particular, becoming increasingly complicated and expensive to produce. In North American shale oil and gas reserves, which entail declining production costs, the majors only play a minor role.
The large oil groups have nevertheless continued to increase their dividends in a bid to keep shareholders on board. Even with the oil price at 100 USD, dividends could not be financed by operating cash flows. Instead, they were funded with new debt, issuance of new shares or the sale of participations. Exploration expenditure needs to be drastically cut, but would lead to a significant reduction in production volumes. The big integrated oil groups are therefore likely to continue to trade at low valuation multiples.
Nevertheless, the energy sector provides attractive investment opportunities, even with oil prices significantly below 100 USD. These can be found primarily in mid and small cap producers, which have the lowest production costs in the sector. Many of these are North American shale oil and gas producers such as Memorial Resource Development, Cardinal Energy or Torc Oil & Gas. These companies can grow even with oil prices at current levels. They can also finance investments and dividends with operating cash flow, and make acquisitions. We also see very interesting investment opportunities in renewable energy, especially in the US solar market and the wind market in emerging economies.