Oil assets under pressure

Commodities have borne the brunt of financial markets’ reaction to the risks associated with the coronavirus outbreak. Together with basic resources, oil companies have been particularly hard hit, with their share prices dropping 20% since the beginning of the year. Such dramatic moves often reflect overreaction to renewed uncertainty, but in the case of oil, the epidemic may just have been the catalyst that triggered the beginning a long-awaited transition.

The outlook for oil prices remains highly uncertain. While we believe that OPEC+, consisting of the 14 members of the Organisation of Petroleum Exporting Countries and allied producers, will likely intervene if Brent crude stays under $50 per barrel for a few months, there could be further weakness before production cuts are implemented. In addition, with spot prices below forward prices (when the forward curve is said to be in contango) investing in the commodity isn’t as compelling at the moment, in our view.

Limited opportunities in fixed income

Looking at asset classes, we see limited opportunity in fixed income. Indeed, the oil price weakness has not caused investment grade credit spreads to widen much globally. In fact, spreads in the energy sector expanded by a mere 10 basis points (bps) on average. In the more speculative US energy high yield space, spreads have widened by 120bps. Although these spreads are wider than they’ve been in the past three years, we don’t see the risk/reward as compelling enough given the higher default risks.

Are oil shares a value trap?

In the equity space, while the sector is undeniably cheap and offers attractive dividend yields, we fear that this apparent opportunity is, in fact, a value trap. Of course most oil companies remain profitable and cash flow positive at current oil prices, but this may not be enough to convince us, and the market, to buy their shares.

Stranded assets and climate change risk

Indeed, with climate change becoming an ever growing source of concern, we see two main factors affecting investors’ demand for fossil fuel-related assets: one is fundamental and the other sentiment-driven. These headwinds are not related to any short-term supply and demand shock, they are more powerful and much more difficult to model.

From a fundamental standpoint, the biggest risk faced by oil companies is  related to assets becoming stranded. According to some estimates, around $900bn worth of oil reserves – or around one third of the current value of big oil and gas companies – could be written off if governments around the world restricted production of the commodity to curtail the rise in temperatures to 1.5C above pre-industrial levels for the rest of this century.

Sustainability concerns curtailing demand 

From an investors’ sentiment perspective, the weighting mechanism embedded in financial markets has already started to rebalance power away from “polluting” industries and towards more environmentally-friendly alternatives. According to Morningstar, sustainable (ESG) funds, which invest based on environmental, social or governance themes, attracted $20.6bn in new money in 2019, up fourfold on 2018.

Similarly, according to the 2019 Global Impact Investing Network annual survey of member institutions, 15% of the money invested last year was allocated to energy-related investments. And this trend is unlikely to stop: out of the 410 families, family offices and foundations who completed the Global Impact survey, sponsored by Barclays, 60% plan to invest in clean energy and green technology this year.

But buying opportunities still exist

Despite attractive valuations, challenging fundamentals and investors’ push to avoid companies exposed to fossil fuels does not bode well for energy assets. However, we believe that there may be sound reasons to consider the other side of this trade.

The process of transitioning from a fossil-based energy mix to a more sustainable one will take years if not decades. This transition, like any other paradigm shift, will see winners and losers. However, ironically some oil companies, while part of the original problem, will most likely be part of the solution too. This is why most major oil producers have been gradually developing renewable divisions and channelled capex away from oil exploration (see chart). As such, they should not be written off just yet. Over the medium term they may hold the key to a successful energy transition.

Similarly, as investors seek greener alternatives, we believe it is crucial to differentiate between aspirational and actual, credible solutions to reducing climate change risks. When it comes to driving the energy transition, we see more immediate opportunities with companies offering a proven, profitable business model as these provide an immediate positive impact on the environment while maximising potential returns for the investors financing them.

Related articles

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

This document has been issued by the Investments division at Barclays Private Banking division and is not a product of the Barclays Research department. Any views expressed may differ from those of Barclays Research. All opinions and estimates included in this document constitute our judgment as of the date of the document and may be subject to change without notice. No representation is made as to the accuracy of the assumptions made within, or completeness of, any modeling, scenario analysis or back-testing.

Barclays is not responsible for information stated to be obtained or derived from third party sources or statistical services, and we do not guarantee the information’s accuracy which may be incomplete or condensed.

This document has been prepared for information purposes only and does not constitute a prospectus, an offer, invitation or solicitation to buy or sell securities and is not intended to provide the sole basis for any evaluation of the securities or any other instrument, which may be discussed in it.

Any offer or entry into any transaction requires Barclays’ subsequent formal agreement which will be subject to internal approvals and execution of binding transaction documents. Any past or simulated past performance including back-testing, modeling or scenario analysis contained herein does not predict and is no indication as to future performance. The value of any investment may also fluctuate as a result of market changes.

The value of any investment may also fluctuate as a result of market changes.

Neither Barclays, its affiliates nor any of its directors, officers, employees, representatives or agents, accepts any liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this communication or its contents or reliance on the information contained herein, except to the extent this would be prohibited by law or regulation..

This document and the information contained herein may only be distributed and published in jurisdictions in which such distribution and publication is permitted.  You may not distribute this document, in whole or part, without our prior, express written permission. Law or regulation in certain countries may restrict the manner of distribution of this document and persons who come into possession of this document are required to inform themselves of and observe such restrictions.

The contents herein do not constitute investment, legal, tax, accounting or other advice. You should consider your own financial situation, objectives and needs, and conduct your own independent investigation and assessment of the contents of this document, including obtaining investment, legal, tax, accounting and such other advice as you consider necessary or appropriate, before making any investment or other decision.

THIS COMMUNICATION IS PROVIDED FOR INFORMATION PURPOSES ONLY AND IS SUBJECT TO CHANGE. IT IS INDICATIVE ONLY AND IS NOT BINDING.