Is investing in oil and gas stocks a good idea?

The fortunes of the oil and gas sector have long been linked to the ebb and flow of the global economy. After a period of strong performance, fears over slowing economic growth and recession have sent share prices across the sector lower over the past few months. However, we believe there are reasons to look at the energy sector differently today. A combination of structural factors and the strength of companies themselves make it an interesting prospect. In our opinion, the sector is also less sensitive to economic cycles than it was.

Oil and gas companies are generally in robust health with sound balance sheets, strong cashflow and low debt. Profitability has enhanced through capital discipline and consolidation. Companies learned their lessons in the last commodity cycle and have been careful in bringing on new supply. Rather than investing in new sources of oil and gas, they have sought to work their existing assets harder.

The climate agenda has also influenced investment decision making. The CEO of Chevron, Mike Wirth, recently said that the price of oil no longer influenced the group’s capital allocation and investment decisions. He said governments had made it clear they didn’t want fossil fuels, so the group would not invest in new supply. This is being seen in the oil rig count, where investment is coming only from a handful of smaller companies rather than the oil majors.

As the chart below illustrates, listed global energy companies (mainly oil and gas) have seen their free cashflow soar past $1 trillion per annum, against $410 billion when the Paris Climate Agreement came into force in November 2016. Since then, capital expenditure was broadly stable at under $400 billion. As a result, only 37% of free cashflow is now used for capital expenditure, some of which will be spent on the maintenance of existing projects. Higher prices may galvanise companies to make tentative investments in new supply, but there will be no quick fixes.

We believe stock markets have been slow to reflect the strength of earnings for energy companies. In spite of strong earnings, share prices fell in June and July with some profit taking. In our opinion there is still room for earnings to make progress – and for share prices to rise relative to earnings.

Valuations are still cheap relative to the sector’s history and to other sectors. Energy currently sits at 7.4 times forward earnings, cheap relative to its history. This is despite the outperformance seen over the past 12 months.

Energy is a clear beneficiary of higher inflation. Our research shows that the energy sector outperforms in periods of higher inflation – by an average of 8%. The analysis looked at the performance of the energy sector, since World War II, when inflation was running at over 6%.

Energy has also proved defensive to some degree, even if this isn’t how it is viewed by most investors. It has been the most resilient sector during the recent downturn. Today, we see it as an increasingly attractive sector – dividends and share buybacks are likely to drive share prices, thanks to strong cashflow and low debt. For example, Shell is expected to buy back 12% of its market cap in 2022, boosting dividends and earnings per share for the remaining shareholders.

A final consideration is that, in recent years, energy has been thought of as a ‘sin’ sector, which is a sector that is deemed unethical. These sectors often become unpopular, prompting investors to sell. And as share prices drop, this can leave valuations attractive. In the case of the energy sector, some of the big oil companies are now involved in significant renewable energy projects so there is the potential for the sector to regain its popularity.  The important factor is how it is perceived by the market.

Weakening economic growth has historically influenced energy demand. However, during this period of economic weakness there has been very little demand destruction. Instead, Western countries are trying to build up their energy supplies so we should expect demand to remain relatively strong.

A rapid increase in supply from an alternative source is a risk to the outlook. As an example, if OPEC (the Organisation of the Petroleum Exporting Countries) was to suddenly increase the supply of oil – although there is no sign of OPEC stepping up production to help bring more oil to the market. Anecdotally, it seems that OPEC is concerned about the negotiations between the West and Iran. It is possible the US might do a nuclear deal and allow Iran to supply them with oil again. Overall, we think a sudden influx of alternative supply is unlikely.

Stripping out the impact of the US dollar (oil is priced in dollars), the oil price appears fair value based on demand and supply dynamics. The real risk is if the dollar keeps rising and the price of oil follows. This gives more downside risk for European buyers as oil becomes more expensive for them. The supply constraints are still in place and should support the crude oil price at a fairly elevated level compared to its history.

We believe this argues for a higher weighting to the oil and gas sector, whether investors opt for an actively managed collective fund, or individual holdings in oil and gas companies. There are structural drivers for the sector, challenging the view that it only thrives during periods of economic expansion. We think this time things could be different.

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All data is sourced from Evelyn Partners/Refinitiv unless otherwise stated.