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Oil: taking the plunge

What does oil’s rebound mean for investors?

17 April 2019

After spiralling by 45% in Q4 last year, oil prices have rebounded close to 50% from their lows, according to West Texas Intermediate figures.

With the barrel slightly above $60, many investors are wondering if energy equity represents an attractive investment.

Given our expectations for a slightly higher average oil price in 2019 - around $70 per barrel - our immediate response would be “yes”.

However, not all oil companies are made equal; it’s important to target specific parts of the sector.

US vs. Europe: a very different proposition

There are significant differences between US (XOP) and European (SXEP index) oil sectors.

The European oil sector (SXEP Index) is mostly comprised of integrated oil companies with exposure to the entire oil production value chain.

On the other hand, in the US, exploration and production (E&P) companies represent the vast majority of the energy sector (roughly 80%).

Pick your position: up, mid or down

Understanding the composition of an oil index is critical as each point in the value chain (up-, mid- or down-stream) responds to different drivers and the performance of each sub-sector relative to the underlying commodity may vary significantly.

Part of value chain

Sector

Drivers

Upstream

Exploration

Oil prices, production growth

Midstream

Storage & Transport

Production growth, oil curve

Downstream

Refiners

Spread, capacity, inventories, transport costs

Broadly speaking, the closer you are to the well, the more exposed you are to the variations in oil prices.

While it does make sense to see E&P’s performance mimic oil prices, the behaviour of services companies may be more surprising.

A lagging second derivative

Oil services companies’ share prices appear to follow oil prices, but this has little to do with any real and immediate impact.

Indeed, this group’s revenues are not linked to the price of oil but rather to E&Ps’ propensity to invest.

This is why earnings for services companies tend to bottom or peak slightly later than E&Ps and to exhibit much larger swings: oil prices and E&Ps earnings are ‘only’ 30% and 40% below their 2015 peak, respectively. Meanwhile, services companies’ earnings are still 70% lower.

We doubt this is about to change.

This year’s consensus estimates have seen steady downgrades for oil services companies, while E&Ps saw upgrades between June and November 2018.

Similarly, the latest rebound in oil prices triggered modest upgrades to E&P earnings forecasts while services’ have remained stubbornly flat.

Oil prices chart

We believe the market is gradually coming to the realisation that services companies, although they may eventually benefit from higher oil prices, are also facing powerful and secular headwinds - chiefly a tech-induced deflationary cycle. This will likely weigh on their growth outlook.

We believe the market is gradually coming to the realisation that services companies, although they may eventually benefit from higher oil prices, are also facing powerful and secular headwinds

What does this mean for investors?

Oil is an eclectic sector: finding the right position in the value chain at any point of the cycle is critical.

In the current context, and based on our expectations that oil prices are unlikely to move significantly higher from here, we expect oil services companies’ earnings power to remain challenged, especially as major integrated oil companies are unlikely to ramp up investments.

E&Ps (US) and integrated (Europe) appear more attractive to us.

Although the resurgence of mergers and acquisition (M&A) activity in the former may offer additional upside, at this point, our preference goes to European majors. We believe they offer a better degree of visibility and better resilience, should oil prices settle at or slightly below their current levels.

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