Sector spotlight: oil and gas

Few sectors have taken a bigger hit than oil and gas. Let’s drill down.

Article updated: 27 May 2020 9:00am Author: Michael Baxter

Before there was Covid-19, there were fears about climate change. Personally, I think the markets have been dramatically underestimating the impact that climate change will have on fossil fuels.

In combination with climate change fears, we have seen the cost of energies generated by renewables collapse. See this report for the latest. The author Ramez Naam has been a great advocate of renewables, but it seems that even he has underestimated how rapidly the cost was going to fall. Let me cite a key paragraph: “Solar has plunged in price faster than anyone – including me – predicted. And modelling of that price decline leads me to forecast that solar will continue to drop in price faster than I’ve previously expected, and will ultimately reach prices lower than virtually anyone expects. Prices that are, by any stretch of the measure, insanely, world-changingly cheap.”

The oil industry had problems. The Covid-19 crisis has compounded these issues.

Will it recover? Of course it will recover to an extent. Between now and the end of the decade, I am sure the oil price will rise somewhat but I don’t think the long term prognosis is very good at all.

Then again, shares have fallen so much, that maybe there are some bargains out there, maybe the markets have overdone their selling.

So let’s look at some names. I focus on companies listed in the UK.

Tullow Oil: Last year things were tough. The CEO left, the company halted its dividend payment and reduced its estimate in reserves. Since then, it has been trying to reduce debts. Things have been looking better, with the sale of Uganda interests to Total for $575 million in cash and the appointment of new CEO, Rahul Dhir. But debt levels remain high. Shares are less than a half the year high, but frankly, I can see why.

Cairn Energy: Before Covid-19 things were looking good at Cairn Energy, pre-tax profits had gone from minus £928m in 2018 to £91m. Revenue had jumped from £314m to £409, and while it saw bad news with a disappointing update from its Chimera well in the North Sea, it increased reserves in Senegal and North Sea and success in oil exploration in Mexico.

Simon Thomson, chief executive of Cairn Energy, said: “The sale of Cairn’s Norwegian business, combined with exits from exploration positions in Ireland and Nicaragua, demonstrate continued focus on capital allocation as the company seeks to generate further value for shareholders on a sustainable basis.”

Under normal circumstances, I would say that Cairn Energy is a good company. But these are not what one might call normal. Recently, Thomas Martin from Numis waxed lyrical about the company, saying: “In all reasonable low oil price scenarios, net debt remains well below the expected borrowing ceiling in the near-term.” He suggested that the oil price would need to be below $30 for three years for net debt to become a source of concern. Right now, Brent Crude is trading at €33.90 a barrel.

The share price is down 40 per cent from the year high, and the P/E is now 7.

Royal Dutch Shell: Shares are down 42 per cent from the year high, and are less than half the all-time level set in 2018.

Back in April, the company revealed it was cutting its dividend. This surprised many. I find it surprising they were surprised. Under current conditions, cutting a dividend makes complete sense. The entire oil industry has got its work cut out just to survive over the next two decades. Companies pay out big dividends when they operate in mature industries. Royal Dutch Shell does not operate in a mature industry; it operates in an industry in long-term decline. It has to diversify, and within the industries it must diversify into, it is like a startup. And startups don’t pay dividends.

Then again, last year the company saw earnings hit $16.5bn, which was 23 per cent lower than the year before. It had been planning a share buyback — this now looks unlikely.

But I think a share buyback was, in any case, crazy, assuming that Royal Dutch Shell wants a long-term future. Debts at the company are not trivial, but under normal conditions, they were eminently affordable. But we are at the stage in the energy market where fossil fuel companies need to be cash-rich. Royal Dutch Shell is a great long term performer, but right now shares are at their lowest level since Royal Dutch and Shell shares began trading as one entity.

Of course, this may mean that shares are so cheap they are now a bargain. Do you believe in oil long-term? If you do, then Royal Dutch Shell may be the company for you. I have my doubts.

BP: Quelle surprise, shares have tumbled this year, falling by 40 per cent this year. Shares are currently slightly lower than the level they fell to at the worst point following the Gulf of Mexico oil spill. One could say that the lesson of the BP share price post-oil spill is that in the case of a strong company like BP, disasters are buying opportunities. Then again, if you are a long-term investor, right now, the BP story does not look so good. BP shares are currently at their lowest level since 1996. Okay, their dividends have been good, so an investor who bought them has not seen a terrible performance, but zero growth in 20 years is not so impressive.

I am being a tad harsh. I am comparing BP shares at the moment of the worst crisis since way back when with its share price under normal conditions.

But what does make BP interesting is its commitment to diversify into sustainable energies. It has the target to be carbon neutral by 2050. I like its new boss, Bernard Looney — I even follow him on Instagram (not sure why, the only other posts I follow on Instagram relate to my daughter’s dog).

If I have to criticise, I would have said the carbon-neutral target by 2050 lacks ambition, but I guess Mr Looney has to maintain credibility with investors — if he said the plan was to be carbon neutral by 2035 no one would have believed him. But, the markets are significantly underestimating the impact renewable energies will have. Of all the oil companies, BP tops my list of companies most likely to make the transition away from fossil fuels. Even so, and even under the more than capable leadership of Bernard Looney, BP won’t find it plain sailing. If someone put a gun to my head though and insisted I had to take a long or short view of BP over the next two decades, I would probably say ‘long.’

Some other oil companies

Hellenic Petroleum. Shares are down by around a third this year. This Greek based oil refiner actually revealed an increase in first-quarter core profits, although after taking into account the fall in the value of oil reserves, the company saw a net loss of $341m. In any case, the real hit on the oil market occurred after the period pertaining to those results. But the company has a strong cash position. The company is also investing heavily in wind and solar power — and Greece certainly has plenty of both. Maybe worth keeping an eye on.

Gulf Keystone: has seen shares fall by two thirds for year peak. But falls seen this year are nothing compared to falls seen in 2015 and 2016. During that period, shares dropped from 3,500 to 200p or so, within around 12 months. The current share price is 73p. The company operates in Kurdistan region of Iraq and actually, last year it seemed to be turning a corner. But challenges lie ahead, although I note its net cash position is not bad, and should be high enough to see it through current awful market conditions.

GeoPark: is an oil and gas company operating in Latin America. Shares are down around 60 per cent from year peak. Its last set of results saw oil production increase by almost a fifth in Q1 of this year compared to the same quarter last year. Even so, it made a net loss of $89.5m against a profit of $19.7m a year earlier. Net debt increased over the year from $294m to $694. On the other hand, it has $165.5 million in cash. What worries me is that crash in profits to losses occurred because of a fall in the oil price. In Q1 2019 the average price of Brent Crude was $63. In Q1 of this year, it was $50. How will it cope when Brent is hovering around $30?

Imperial Oil shares: are down by around a third from the year high, but the share price has been steadily falling for several years. The company specialises in Canadian resources, especially oil sands. Pre-Covid, it’s balance sheet looked strong, but workers at one of its key sites tested positive for Covid, forcing a temporary shutdown. It made a net loss in its first quarter of $118m.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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