Asset Allocator: June 2015- Energy Sector Blues?

Following on from his look at the price of oil in last week's article, David Stevenson turns his focus to the energy sector where the oil price crash has produced uncertainty for producers and distributors alike. David looks at the prospects for price rebound, the likely headwinds pulling the industry down, how changes in the spot price will reflect on equities and how market analysts are evaluating the situation.

The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes no responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear. 


 ASSET ALLOCATOR: JUNE 2015

01/06/15- Energy Sector Blues? 

 

One of the most compelling investment stories of the last 12 months has been the zigzagging fate of the global energy sector. In the second half of 2014 the oil and gas industry was plunged into turmoil as the Saudi government kicked off a determined campaign to regain the title of global oil price arbiter. Annoyed by the rapid growth of unconventional sources of both oil and natural gas in North America, the Saudi’s broke decades of OPEC discipline and announced that they’d do whatever it took to push these new suppliers out of the market. As oil prices collapsed, oil sector equities plunged in value.

Plunging Prices : The energy sector and recent returns (source SG Quantitative Research May 18th

 

We’re now due another imminent OPEC event – the world’s leading oil ministers are due in Vienna this Friday for their 167th meeting. Most analysts expect no change to OPEC’s production ceiling of 30 million barrels of oil a day and it’s fair to say that OPEC has held firm on its commitment to current output levels in an effort to support prices and let the market balance itself – that policy is expected to continue. A Bloomberg survey says OPEC members pumped 31.3 million barrels a day in April.

Whatever happens in Vienna, many investors are now beginning to look again at the oil and gas sector, especially equities in the world’s leading producers.  Over the last five months of 2015, global investors have pumped tens of billions of pounds into energy sector ETF’s confident that that track the energy sector is finally at a turning point. And that upsurge in confidence is reinforced by commodity prices.  

 

The graphic above shows the price of Brent oil over the last twelve months, plus a whole legion of indicators including the thick green line (the 20 day moving average), the thin blue line (the 20 day moving average), and trend lines suggesting a steep descent (the solid and dotted blue lines). The important line of course is the one in the middle (red and green) which shows that Brent oil prices have rallied in recent weeks to hit about $65 a barrel, clearing all the trend lines, as well as the 20 day moving average. My own guess is that within the next few weeks that price might even clear the 200 day moving average, helping fuel the bullish case for investing in the energy sector.

In this article I want to examine prospects for energy stocks in detail – in last week’s article I looked at the bearish case against investing in the sector. I’ll repeat some of those arguments in more detail in this article, but I also want to take a more balanced approach and examine what might happen if my own bearish views about the oil price prove to be wide of the mark. 

If oil prices do manage to stay in their current $50 to $70 trading range, is now the time to be betting big on energy stocks? 

Without wanting to give too much away at the beginning I suspect that the energy sector is still over-valued even if oil prices remain stable. This article explains why!

The bullish case: catch the rebound!

Yet even I have to accept that my own bearish position doesn’t appear to be borne out by the hard facts on the ground.

A note two weeks ago from Societe Generale’s own oil analysts struck a relatively upbeat tone, observing that oil market stats were “moderately bullish for crude, gasoline, and distillate: stocks drew and demand was solid. Total 4w av product demand growth was strong at 739 kb/d y-o-y (+3.9%) to 19.7 Mb/d. Crude stocks continued to draw seasonally, and we expect crude and product demand to remain supportive as economic activity rebounds following a weak first quarter. Crude production fell by a significant 112 kb/d, but the slide was solely due to field maintenance in Alaska; it is worth noting that supply in Alaska has already returned to normal. Lower 48 output - including shale oil - was flat at 8.87 Mb/d.”

More generally it’s true that oil inventories in the US have continued their decline. Last week the Energy Information Administration said crude stockpiles fell by 2.8 million barrels last week to 479.4 million barrels. The American Petroleum institute had predicted a build in stocks and the decline was much more than most analysts had expected.

Most analysts think that prices will start to steady and then rise this summer, helped along by a number of market drivers. The summer driving season in the US is nearly upon us, and the Memorial Day holiday is usually the start of the upbeat summer season for the energy sector.

Some institutional investors are also turning bullish. Bank of America Merrill Lynch put out a note last week for instance telling clients now is the time to buy. Hedge funds have already pounced. The 50 largest hedge funds bought a lot of energy stocks (e.g. Williams Partners, Energy Transfer Partners and Kinder Morgan) in the first quarter while analysts at Bank of America reckon "the bottom is well behind us."

That cautious optimism is also very clear in recent numbers coming out of the global energy sector. For UK readers its worth focusing on a recent note by analysts at research firm Edison on Shell and BP to examine this rebound in confidence. Edison note that Shell’s first quarter results for 2015 “beat consensus expectations by ~30% …..thanks to a blowout quarter in refining & marketing. Its downstream division posted the best quarterly earnings since the 'golden age of refining' in 2006-07. Refining and marketing profits were buoyed by strong global refining margins, cost savings initiatives and a healthy contribution from trading. Other majors with high exposure to downstream such as Exxon should also benefit from the current favourable refining environment, highlighting the value of integration”.

Over at BP the numbers were slightly less upbeat but still positive overall. Edison observed at the end of April that “BP's first-quarter results came in slightly better than expected; however this was largely thanks to one-off positive UK tax effects (as BP booked the benefit of the North Sea tax reduction in the quarter) rather than stronger underlying performance. BP's upstream profits were hit by lower oil and gas prices as well as break fees for two deepwater rig contracts in the US Gulf of Mexico, which sent BP's US upstream business into a loss. Rig cancellation costs are likely to show up in other major results this quarter, as all majors rein in offshore drilling activity. On a positive note, BP appears successful at cutting costs as it took a number of simplification and efficiency measures early and aggressively, but this is not yet enough to offset the weaker macro. Results were also boosted by a buoyant downstream, once again demonstrating the value of integration. Majors with high downstream exposure such as Shell, Total or Exxon should benefit from the strong global refining environment, which BP expects to last into the second quarter”.

Earnings have rebounded in the all-important US as well. A note from analysts at research firm Zacks in the US looked at Q1 numbers for the sector and found that profits were surprising to the upside by an average of 6% across the board in the S&P 500. According to the Zacks’ analysts the US energy sector was helped along by strength “in refining, effective cost management, and less currency drag than analysts expected are among the factors that contributed to the energy sector’s better than expected performance this earnings season as oil prices fell during the first quarter. Services and equipment companies within the sector suffered smaller losses, although the broad sector is still tracking to a massive 58% decline”.

If we assume that oil prices continue to stabilise – a questionable assumption in my opinion but not at all unreasonable – what might happen next to the energy sector?

At this point in the debate its worth reprising a fascinating analysis from analysts at US bank Morgan Stanley from back in the second half of 2014. Back in December 2014 MS analysts surprised many investors by going overweight energy stocks – their explanation was that energy sector was not only looking reasonably valued but was also due an aggressive rebound in profits.

On that earnings rebound argument the Morgan Stanley analysts found that historically “the Energy sector reverses strongly over the subsequent six months when it was preceded by this behaviour — i.e., “worst-to-first” In fact, we analyzed seven prior periods or phases when Energy has underperformed the market by as much as it has recently, and in all cases, the Energy sector outperformed the market over the subsequent six months (table below)”. 

 

Morgan Stanley’s other major conclusion was equally revealing namely that energy stocks tend to bottom out two months before earnings revisions bottom. According to the MS analysts their analysis showed that “the correlation between the change in the net income of the Energy sector and the change in the oil price is 0.8. It is therefore clear that material downward earnings revisions for the Energy sector are imminent. Given the substantially lower oil price, we expect negative earnings revisions for the Energy sector during January earnings season. The question is timing”.

 

 

But valuations still look stretched

Yet even if we do accept that oil prices have begun to stabilise, I’d still be cautious about making a big move back into energy equities through a global sector ETF tracker.

The next three tables below I think elegantly and succinctly sum up why the energy equity sector is not looking compelling value – even if we assume oil prices remain stable.

The tables are based on quantitative research from Societe Generales equity research team and look at key fundamental measures such as the price to earnings ratio, dividend yields and earnings per share growth rates for 2014 and 2015.

I’d highlight three simple observations:

1.     Global developed world energy stocks may yield a decent 3.7% yield but at 23 times estimates for 2015 earnings, they are relatively expensive.

2.     US oil equities (the largest component in any energy sector tracker) are looking very expensive at 32 times estimates for earnings in 2015

3.     UK oil equities look much better value at 18 times earnings and on a yield of not far under 5%.

 

Energy sector Dividend Yields  

 

For me the most troubling numbers relate to the US energy sector – the last table below puts numbers for the businesses contained within the US energy sector under the microscope. They’re based on research from Morningstar using their own internal business cash flow models.

The ETF under analysis is from State Street and has the US ticker of XLE. A quick perusal of the numbers reveals that on virtually every key fundamental metric the US energy businesses tracked within this index and ETF are trading at above 10 year trailing averages.

US oil and Gas Sector valuations: based on US ETF Energy Select Sector SPDR (XLE) 

 

Given these value orientated metrics it’s not surprising that respected market analysts in the US such as Ed Yardeni maintain that “the energy earnings outlook still remains pretty dismal compared to a year ago". On his own numbers energy sector stocks had a P/E ratio of 14.1 in May 2014 while the sector now trades at 26.5 (based on forward earnings), well above the level for the S&P 500 P/E which is just shy of 17. "It's actually not cheap unless you think oil prices are going to rebound more”,  Yardeni says.

I’d also observe that there are growing lists of headwinds likely to dampen down market optimism for energy stocks over the summer. Analysts at Morgan Stanley recently updated their investors by warning that they’re currently seeing a big increase in hedging activity. They also observed that the stronger oil price is encouraging some American producers back into the market. The American rig count is around 659, but the decline has been much slower than previous months. Commerzbank says the WTI price is now at a level that makes “the production of shale oil attractive again”. If these banks are right, it’s clear that the huge oil supply interruption imagined by the Saudi’s has singularly failed to happen.

And I think it’s fair to say that these ‘headwinds’ have not gone unnoticed by mainstream institutional investors – they’re beginning to pull money out of energy stocks globally. A recent report on Bloomberg News observed that “investors are cautiously pulling money out of energy producers for the first time in eight months…More than $1.55 billion has been withdrawn this month [May] from exchange-traded funds concentrated on energy stocks such as Exxon Mobil Corp and Chevron Corp. It’s on pace for the first monthly setback for the group since investors began pouring into the sector in October with an eye toward profiting from an eventual recovery in prices".

On May 1st for instance Bloomberg reported that energy ETF’s lost $475.8 million, days before U.S. crude closed at this year’s high of $60.93 a barrel on May 6, ending a 49-day rally from a six-year low of $43.46 on March 17.

Bottom Line

If all this uncertainty wasn’t enough I’d also make one last final observation – the US economy matters the most. If the US economy shows signs of expanding at an even faster rate, demand for oil may increase substantially, potentially under pinning another rally in energy equities. Yet I’d argue that there are signs that the US economy actually shrank in the January-March quarter for a second straight year, partly caused by a cold winter, a decline in the energy sector and an export slump caused by a higher dollar.The optimists would argue that this analysis is too dismal - according to Moody’s Analytics, US growth is expected to reach an annual rate of around 3.5 percent in the second half of the year. It’s also true that the US is experiencing stronger jobs growth and increased consumer spending. Moody’s says annual growth should be around 2.5 percent. And growth rates are picking up in the emerging markets.  India is likely to reveal an acceleration in growth while energy website Oilbarrel.com reports that “oil demand in China is on the increase, up more than 5 percent to more than 10 million barrels a day. The country’s President Xi Jinping said he wanted to increase China’s strategic oil stockpiles, as they are significant to the country’s energy security.”

Yet despite all this optimism about the US and global economy I’d simply observe that it’s perfectly possible to believe in an upturn in growth and still anticipate FALLING oil prices. Put simply, there’s a huge amount of spare oil producing capacity out there at the global level, and any surprise to the upside in terms of global growth can easily be accommodated by pumping more oil out of the ground. On that note I’d simply remind readers that last week’s EIA Petroleum Status Report showed field production of crude oil rose by 304,000 barrels a day to 9.57 million barrels a day last week – this production is now at the highest level since records began in 1983.

Even if investors don’t believe oil prices are due another big correction – my own core view – they should avoid the energy sector for now. It’s overvalued as an equity sector, producing too much oil at the global level and hasn’t cut back its capex spending aggressively enough. Stay underweight energy, we’ve not seen the worst yet in terms of share prices. 

 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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The indices referred to herein (the “Indices”) are not sponsored, approved or sold by Societe Generale. Societe Generale shall not assume any responsibility in this respect.

 

 


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