The essence of L’Essence

The European equity team in Henley has been overweight the energy sector since late 2013. With renewed commodity weakness of late, why do the team continue to add to positions?

The team’s ownership of energy companies is not a pure play on the oil price. Our interest in the sector was originally piqued by valuations, but the decision to actually own the stocks was driven by the potential for change in underlying returns of the companies. Put simply, we believe these businesses will be better businesses, at any oil price, in the future than they were in the last cycle – measurable by them generating higher returns and cash-flow per barrel moving forwards.

Historically, the sector was dominated by a race for production growth. Input costs rocketed as oil companies competed for scarce oil service supplies. This meant that returns dropped even in an environment of high oil prices. The turning point for us came in late 2013 and early 2014 when new management teams across the sector (often appointed from downstream functions) demonstrated a change of tone. Focus became ‘value over volume’. We heard countless examples of supply inefficiencies, gold-plated capital investments, and unrealistic break-even assumptions. The bad news was how badly the industry had been run in recent years. The good news was how much fat there was to take out, and the determination to do it.

Then the oil price collapsed. Whilst clearly the sector came under pressure in the equity market, from an operational perspective this was the environment the new CFOs needed to truly drive change through their organisations. Time and again we heard management talk of not wanting to waste the opportunity presented by a crisis. Accordingly we continued to raise allocations.

The focus on operations and returns is all well and good, but we realise as an investment strategy we need some visibility in the oil price – or at least some form of stability. The important element in the oil price decline from the middle of 2014 was that it was supply not demand-led. A combination of huge growth from the shale fields of the US, and OPEC (Organisation of the Oil Exporting Countries) removing production limits and competing for share led to over-supply. As figure 1 below shows, demand has grown steadily by over 1mbpd (million barrels per day) each year over the long term and is forecasted to continue to do so.

Two elements dominate views of supply in the mid-term:

1. In November 2016 OPEC decided to return to acting as a swing producer, and agreed production cuts amounting to 1.2mbpd (>1% of the market). Compliance thus far has been high (around 93%), but fears that countries will renege on that compliance, and that there will be unwillingness to extend the cuts has been in part the source of recent oil price weakness.
   As an exercise, we analysed flexed global demand/supply balance (see figure 2) assuming all of the OPEC supply comes back into the market. We would still see balance in 2017 – albeit later and not to the same extent as currently assumed.

2. US shale remains a very flexible source of oil, and strong results from US based E&P companies have caused many to believe that there is an endless supply of shale and hence no real upside to oil prices.

There are two solutions to this; either shale entirely fills the gap, or the extra supply comes from other sources. In both cases, what is required is a higher oil price. Oil taps have been turned on again in US shale, but the 2020 figure would require an almost doubling of currently US production levels, when 2 out of 3 major shale fields are already in significant decline, and the other has already passed the point of low marginal cost. We have heard from a number of sources that from this point, unit costs go up for shale. The gap cannot be closed at these prices.

Ultimately, therefore, oil demand and supply will go into balance. Oil commodity prices can be dominated by short-term trading, but we see no reason to change our underlying assumptions that the oil price will need to go up over time, albeit to levels well below the previous peak.

What has become crystal clear over recent quarters, however, is that the underlying thesis behind investing in integrated oil equities is coming through – and even more convincingly than we estimated. Across the board we have seen companies reduce the oil-price break-even point at which they cover dividends and at which they become free cash-flow positive.

The sector has seen Free Cash Flow (FCF) inflect despite the oil price being less than half previous peak. In aggregate the European Integrated oil sector has reduced the oil price at which FCF covers dividends from $119/barrel in 2014 to $54/barrel today, with some companies already covering dividends below $50/barrel. Whilst the market marks the sector on day to day gyrations in the oil price, our focus is instead on the underlying cash-flow of the industry. As shown in figure 4, the sector’s cash generating capabilities are inflecting even with oil prices at half the previous peak.

It is cash-flow which ultimately underpins the ability of a company to pay a dividend yield. Current yields for the sector are extended versus the market suggesting investors fear that they are not sustainable (see figure 5), and yet cash-flow is improving. Accordingly our view is that yields will compress as the market sees continuing evidence of cash-flow delivery. It is this valuation anomaly that is at the heart of our investment in integrated oil equities and why we remain very confident in our positioning.

Important information

This document is for Professional Clients only and is not for consumer use.

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Where Stephanie Butcher has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.