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Oil ship

Retreat of the majors?

23 February 2016

After last year’s oil slide, share prices of oil majors in 2016 are down dramatically, making them potentially attractive to investors.

It has been quite a slide, and it may not even be over. Having stayed mostly above $100 a barrel from 2011 to mid-2014, Brent crude ended 2015 below $50, and has since struggled to stay much above $30. It has not been at this level since the financial crisis.

Behind the dip in prices lies a supply glut that shows no immediate signs of abating. Yet even if only technical factors are at play, oil is so fundamental to the global economy that its price dip has spooked markets worldwide.

“Currently the oil market is oversupplied by about a million barrels per day,” says Scott Service of Loomis Sayles. “Energy will continue to be an important sector in 2016 and it will also be a weather vane for investor sentiment.”

Initial signs in 2016 have not been good. The New Year has seen major oil companies announce record losses, redundancies and, in a few cases, dividend payment cuts. Shell and BP, the largest and third-largest companies, respectively, on the FTSE 1001, both suffered heavily in 2015. BP announced its worst-ever annual loss (of $6.5 billion) for 2015. Shell published an 80% fall in profits over the year and recently announced plans to divest itself of $10 billion worth of assets.

In the US, ConocoPhillips holds the dubious distinction of being the first oil major to announce a dividend cut since the oil price rout. Two weeks ago, it cut its dividend-per-share from 74 cents to 25 cents. Standard & Poor’s has cut the credit ratings of several leading US oil and gas companies in recent weeks, including Chevron, the country’s second-largest. Shell, like Chevron, has seen its credit rating lowered this year. Such negative signs can easily unnerve investors, especially since oil may remain cheap for some time yet.

“US production is now struggling,” says George Luckraft of AXA Investment Managers. “Production outside OPEC will fall meaningfully in the second half of 2016. Iran wants to turn stored oil into cash, which is a short-term depressant. I don’t think we’re going to go much above $50 – and we won’t see $100 in a calm world again.”

If the leading fear of 2015 was slowing growth in China, this year investors’ attention may well turn instead to cheap oil. Oil majors have traditionally been some of the most profitable companies in the world, a fact that has been reflected in both the safety of their bonds and the reliability of their generous equity dividends.

Yet BP, Shell and Chevron – to name just three of the global majors – have lost between 35% and 50% of their stock market values since their mid-2014 peaks. A downgrade in credit rating, as Shell and Chevron have suffered, tends to reduce the value of a company’s bonds, making it more expensive for them to borrow money from the markets.

Shell’s 10-year bonds have seen their yield double since May 2015. The yield reflects the level of perceived risk that the company will not pay back its debt; in other words, the market believes Shell is twice as risky an investment as it was just nine months ago.

Over a barrel

In this environment, it is worth asking whether investors should seek to cut their losses and run, or whether the fall in prices might instead provide the right opportunity to add to their existing positions.

“Over the past two months, we have been adding in small size selectively to energy companies that have come under pressure from the lower oil price and on which we have a long-term favourable view,” says Service. “These companies are BB-rated [a middle-range rating], low-cost producers and include Concho Resources, Newfield Exploration, SM Energy, QEP Resources, and Range Resources. We have generally stayed away from the larger oil majors as we don't believe the market weakness and potential rating pressure is appropriately reflected in their bond prices.”

The case for continued exposure to shares in oil majors looks similar, but not identical. While credit spreads have widened on the largest oil majors, Service believes they have not widened enough to offer real value. When it comes to equities, however, the opportunity may be imminent, but has not quite arrived, according to Luckraft. Deals for oil-drilling projects are likely to offer much less to oil companies than they did 18 months ago.

“There were a lot of cuts [e.g. on drilling projects] last year and there is more price pressure to come on the bids for projects,” said Luckraft. “It does mean that costs come down for the oil majors – that’s the good news. We saw the CEO of BP yesterday and they are just waiting to put contracts out. By waiting six months they get better prices.”

Despite Shell and BP suffering severely reduced profits, Luckraft expects them to remain committed to their dividend payments. In the current climate, he also expects mergers and acquisitions to continue. On 15 February, Shell completed its $50 billion acquisition of BG Group, making it the largest foreign oil company in Brazil. Further down the food chain, Premier Oil bought up E.ON’s North Sea assets.

“There will definitely be more M&A activity as the large oil companies sell more off,” says Luckraft. “Private equity has funds at the ready to buy up distressed assets.”

1 By market capitalisation. Source: http://www.stockchallenge.co.uk/ftse.php

 

The opinions expressed are those of George Luckraft of AXA Investment Managers and Scott Service of Loomis Sayles, and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or by St. James's Place Wealth Management.

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