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Power struggle – Oil companies may look cheap but there are some very good reasons for that.

15/07/2015

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

“If you are long commodities, you are short human innovation” may have been first suggested as an idea some five years ago by the then Société Générale strategist Dylan Grice but it has become something of mantra here on The Value Perspective as we strive to make some sense of valuations in the oil sector.

Judged by one of our favourite metrics, the Graham & Dodd price/earnings ratio, oils stocks do look cheap and yet we continue to steer clear of them because we remain concerned about their free cashflow. As we explained in The generation game, what interests us most as value investors is cash because it is cash that enables a business to pay a dividend and to reinvest in itself.

Still, in a world of generally rising valuations, an investor might be forgiven for willing oil stocks to reveal themselves as being genuinely good value. Any risk that we might delude ourselves in this regard, however, has been significantly reduced by some very interesting charts produced by David Scott, founder of the Chaam Advisors research service.

Since these charts compare the production costs of oil and oil’s great rival, natural gas, it is worth sketching in a few explanatory notes in advance. First, to facilitate price comparisons, analysts talk in terms of ‘British thermal units’ or ‘BTUs’ for short. A million BTUs is roughly equivalent to the energy produced by seven gallons of gasoline or 950 cubic feet of natural gas.

The thing is, the prices for one BTU of oil and one BTU of natural gas are not the same and, to further distort matters, the cost of finding natural gas is falling – score one point for human innovation – while, with their existing reserves and current fields running down, the oil companies are having to drill in increasingly inaccessible, and therefore costly, areas.

And while the natural gas sector may have seen a lot of innovation – fracking being the most high-profile example – that has not happened to nearly the same degree in the much more conventional business of oil. All of which means that, as you can see from the chart below, where for years there was cost parity between the equivalent energy produced by oil and gas, now there is a sizeable spread.

  

Source: CHA-AM Advisors  - US Department of Energy

The spread may have narrowed over the last 18 months or so but the fact remains that, if you are in a position, say, to put BTUs of energy into your car via electricity rather than via than the gas tank, then you are looking at a very good trade. Ominously for oil – and score another point for human innovation – the price of converting natural gas, or for that matter solar, into electricity is dropping every year.

So, of course, the oil price is not just competing against a low gas price that happens to be benefiting very nicely from innovation, it is also competing against lower battery prices, cheaper solar prices and so on. What that means is, just because it is becoming increasingly expensive to find oil, it no longer necessarily follows that the oil price must rise.

To underline that point, here are two more charts from Chaam Advisors. The first shows the spread between crude oil and natural gas in dollars per million BTUs – one million BTUs being, among other things, the rough equivalent of a tank of petrol for a small car – while the second shows how much market share oil has lost to other energy types over the last decade or so.

 

Source: CHA-AM Advisors  - US Department of Energy

 

Source: CHA-AM Advisors  BP Statistics

If you would like to read further into this subject, The Value Perspective whole-heartedly recommends Sustainable energy – Without the hot air. In it, David MacKay, the Regius Professor of Engineering at the University of Cambridge, discusses different forms of energy production and what it would takes to achieve a carbon-neutral Britain – and all, joy of joys, using a standardised unit of energy. You can download the book for free here.

Author

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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