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Steve Davis, Jupiter Unit Trust Managers

Avoiding the oil slick

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Shares in UK-listed oil majors may have further to fall if dividend payouts come under threat from a persistently weak oil price, according to Steve Davies (pictured), co-manager of the Jupiter UK Growth Fund. 

As “potential recovery” plays, these companies are not yet priced attractively enough for us to hold and the best opportunities to benefit from the fall in crude lie elsewhere, he added.

Share prices are unlikely to perk up while the commodity price is still falling, so the first question is whether the oil price has reached the bottom yet? The drop in the last few months has been primarily driven by a supply glut, led not only by rising US shale oil production but also Saudi Arabia choosing to protect its market share rather than defend a particular oil price. At the same time, Chinese oil demand has grown much more slowly compared to the heady days of 2009 and 2010, as the overall economy transitions away from heavy industry and towards services, which are less oil-intensive.

Oil price: ceiling or bottom?

To correct this imbalance, there would either need to be a production cut or demand would have to rise rapidly in response to the lower prices. The latter seems unlikely: US and European demand for oil peaked in 2005 and 2006 respectively so it is hard to see a sudden acceleration from here.

As noted above, Chinese demand growth is more muted and other emerging markets like India are taking advantage of lower prices to reduce government fuel subsidies, so end-users would likely see less of a price reduction anyway.

So what about a production cut? OPEC has recently decided against cutting, for now at least, so the market will have to wait and see if and at what price the US shale producers are forced to shut up shop in substantial numbers. This is not a straightforward calculation for a number of reasons: first, shale costs already vary significantly across different regions of the US; second, a number of producers have hedged their production at higher oil prices so their profitability should be protected for a while; and most significantly, the shale companies are learning all the time so breakeven costs are coming down in many areas.

It is also worth noting that, while a lower oil price might well lead to substantial reductions in US oil production, any rebound in prices could easily bring that production back on again. Perhaps we need to start thinking about a ceiling on oil prices around the USD75-80 level, which is a very different mindset compared to recent years. 

Given this, in the absence of productions cuts from OPEC or additional geopolitical disruptions, it seems sensible for us to invest on the basis that oil prices may not rise much and could easily fall further. One additional wildcard to watch is the possibility of Iran bringing barrels back to market if it were to reach some kind of accord with the P5+1 (the permanent members of the UN Security Council, plus Germany) in relation to its nuclear programme. That could add another 1 million barrels per day to the supply glut.

Are the big oil stocks in “Recovery” mode?

The second question then is whether stocks like BP and Shell now offer enough upside to entice us into buying them. When looking at a potential new investment for the UK Growth Fund, we are looking for either “Growth” or “Recovery” situations, with very specific criteria for each. The big oil companies certainly don’t fit in our Growth bucket – they simply don’t grow fast enough.

When it comes to Recovery opportunities, our antennae start twitching when we see a fair degree of distress combined with potential for substantial upside to our target price (in excess of 35% given the opportunities currently available elsewhere). Yet BP and Shell are only down 10‑15% from their summer peaks and it is probably fair that we assume that this is about all they would recoup in the unlikely event that the oil price quickly shot back up towards USD100.

Why have they not fallen further, given that earnings forecasts for 2015 could end up 30%-40% lower than 2014 if USD70 oil persists throughout the year? The simple answer is that they are backstopped by dividend yields of 5.5% to 6%, based on the current share price. With a yield at that level we would only expect to see valuations become really distressed if investors started to think that the dividends were under threat.

That may happen eventually, but it would take time to unfold. The UK-listed oil majors have strong balance sheets, so for the time being can happily fund their dividends through increased gearing. But that is not a sustainable strategy if USD70 oil is the new normal, so their boards would likely be faced with the difficult choice of cutting capital expenditure or reducing dividend payments. No doubt they would prefer to do the former, but the cuts required would be substantial (as much as 20% by our calculations) and that’s probably more difficult to achieve than is commonly assumed since some inflation has already been locked in. Either way, it may not be a costless exercise for the oil majors: lower capex today means lower production and lower cashflow tomorrow, and that won’t boost the long-term value of the company.

Pulling all this together, we still struggle to see the oil majors as exciting Recovery stories so we will stay on the sidelines for now. However, we shall watch with interest as management teams start to reappraise how they will split their diminished cashflows between capex and dividends – any threat to the latter could certainly provide us with a more interesting opportunity.

Where we see opportunities

In the meantime, we can look to benefit from lower oil prices in other ways. Lower fuel prices should provide a general boost to UK consumer spending, while the disinflationary impact could also delay the first interest rate rise. These factors should help some of our UK domestic holdings, for example Dixons Carphone and ITV.
More directly, IAG and Thomas Cook should experience significant reductions in their fuel bills over the next couple of years and we have been adding to both positions in recent months. To illustrate, Thomas Cook said recently that its fuel bill could be GBP60m-GBP80m lower this year and we estimate that the saving in 2016 could be twice as much. Some of this should be passed back to consumers in the form of lower prices, but even taking that into account we think it should provide a substantial boost to a company that has just reported an operating profit of GBP323m.

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