Last year saw a turbulent journey for oil as demand plummetted due to the pandemic which is continuing to impact the oil companies.
Is oil still a slick commodity?
While the peak to trough decline in oil prices during 2020 was not of the same magnitude as the plunge during the financial crisis, last year was no doubt still one of the most volatile periods for oil prices and the industry, all of which was ultimately due to the global pandemic.
Early in 2020, as demand from China dropped back as the virus took hold, both Russia and Saudi Arabia could not come to an agreement on production cuts to keep prices sustained. Saudi Arabia deemed that Russia was not falling into line so it decided unilaterally to ramp off production, sending prices plunging, seriously hitting Russia along with others along the way.
However, when the virus hit Europe and the US is when the apocalyptic scenarios hit investor’s minds. Stocks were plunging as lockdowns spread with the virus, oil prices plunged further and demand disappeared as stockpiles were building up, even to the absurd point where futures prices went into negative territory. Since that crazy initial period, oil prices have somewhat stabilised but are still trading significantly lower. Naturally this has implications for energy companies. While there is lower demand, there are also lower prices which means revenues and profits plunged with many making serious losses.
In the UK, both BP and Shell for the first time in decades cut their dividend pay-out’s. BP cuts its interims by around half while Royal Dutch Shell took theirs down by around two thirds. Some of the smaller players and oil services companies cut theirs entirely. The big two are amongst the most important companies in the UK for income investors and obviously this is a blow to them. However, I felt that ditching these two on the basis of the dividend cuts would have been the wrong thing to do.
Yes they are both feeling the pinch and have made huge losses on writing down the value of their assets in recent quarters, but these two giants are very well managed and have gone through previous oil slumps and come out on the other side relatively well. This is because they are fairly adept at stripping back costs by using the latest technologies in the extraction and refining processes. I’m sure they will do so this time round as well.
In time we will overcome this virus, people will begin to travel again, demand from industries will resume for manufacturing goods and so forth as vaccination programmes roll out across the world. This optimism is showing up in oil prices which most recently broke past $55 for a barrel of Brent crude, a price level at which most of the big oil companies were easily profitable at before the crisis. This along with OPEC and other major producers expected to better coordinate production, make me sure that oil prices will be higher by year end than where we are now. I therefore think that the likes of Shell and BP make a compelling investment idea for income investors; they offer dividend yields of between 3.5 - 5% which can only grow from here. Meanwhile the smaller oil producers are far higher risk given that they don’t have as deep pockets as the giants and the oil services companies still face the prospect of cost cutting programmes by the majors, but as with all previous periods of intense trauma, investors in those companies that survive this period will be well rewarded in the recovery.
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