Why the oil & gas sector is energising investors

The energy sector saw a rally in April, helped by the oil price moving above $70 per barrel for the first time since 2014. This was good news for us as we have been turning more favourable towards the sector since the start of the year. And prices have continued to climb, edging above $80/barrel in recent days.

But we can’t claim to have had a crystal ball telling us about the oil price rises ahead. Instead, our optimism towards the sector has been based on a number of different factors.

Demand for oil still strong

First of all, demand is not going away. The world’s demand for energy is still on the increase and oil will be needed to meet this. The latest World Energy Outlook from the International Energy Agency predicts a 30% expansion1 in global energy needs between 2016 and 2040, as the pick-up in demand from emerging markets far outstrips the decline from developed markets.

It could be argued that the rise of renewable energy will pick up some of this shortfall in supply but the consumption gap between renewable energy versus that of oil is still substantial. Oil is declining as an overall percentage of energy share; however, when looking at the primary energy consumption by fuel, oil consumption is still rising.

We should therefore not underestimate the role of oil in energy supply over the long term.

Chart of world energy consumption

Supply tightening after underinvestment

Meanwhile, supply looks set to tighten after years of underinvestment by oil companies. Oil prices rebounded quickly after the 2008/09 global financial crisis to trade within the $90-$120 per barrel range for several years. But increases in oil production in the US – particularly shale – saw prices tumble below $30 per barrel in 2014.

With prices sinking and an apparent supply glut from the US, many oil companies cut back on their capital expenditure, i.e. the money spent on finding and developing new oilfields. The result is that we now have a divergence between the amount of oil we know about and the amount of oil we are expected to need.

In fact, 2017 was a record low year for discoveries of conventional oil volumes. The chart below shows how the monthly average volume of conventional oil discoveries dropped last year to around a fifth of the level it was in 2012. With new supply tight, prices look set to rise further.

Chart showing rate of oil discoveries

Opportunities in niche sub-sectors

To our mind then, it seems clear that oil producers need to invest in order to increase the supply of oil. The oil services firms will be the beneficiaries of this investment.

One niche within oil services that we view as particularly interesting is seismic vessels, which are used to discover new offshore oil reserves. As the chart below shows, since 2012 the number of these vessels has dropped dramatically from over 60 to around 20.

Chart showing decline in seismic vessels

The owners of these ships are therefore well-placed to benefit from rising demand, and can lift their prices due to lack of competition.

Valuations suggest the sector looks cheap

Another very important point to mention is that in our view the oil companies appear to be cheap.

Four years of declining oil prices have weighed on the sector, especially as some companies have been forced to cut their dividends or pay them in scrip (shares) instead of cash. The sector as a whole is out of favour with the market.

However, those firms that continued with disciplined investments through the downturn may find themselves in a good position with demand still strong and oil prices back on the rise once more.

Chart of oil sector valuations

In short, we see opportunities in the sector, both among producers and services firms. While global growth may be peaking, and worries abound over trade and geopolitics, the energy sector has a cycle of its own, driven by long-term supply and demand dynamics.

Moreover, we see oil stocks as beneficiaries of inflation which, as we have discussed before (here and here), could be on the way back.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Past Performance is not a guide to future performance.

Any references to sectors are for illustrative purposes only and not a recommendation to buy and/or sell.

1. https://www.iea.org/weo2017/

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