“Fear is the foe of the faddist, but the friend of the fundamentalist.” Warren Buffett
In my previous post I suggested a mental framework for assessing the extent to which irrational fear or greed may be driving financial asset prices. In this post, I will use the framework to assess the current situation in the oil and gas sector1.
Let’s start with past price performance and valuation.
The oil price itself is down 45% in real (inflation adjusted) terms over the past 5 years, most of which has occurred in the past 12 months2. No surprise then that the oil sector has also been very poor in share price terms. The FTSE oil and gas index has underperformed the FTSE All Share by over 45% over the past 5 years3. The huge, diversified and relatively less risky integrated oil majors BP and Shell make up the bulk of this index. Many of the smaller exploration and production companies have performed much worse than this.
Valuations also appear very low and in some cases outright distressed. Asset based valuations such as price-to-book for BP and Shell are at low absolute levels and big discounts to the broader stock market. Even on forward earnings, valuations look low despite the fact that forecasts have already been reduced significantly as oil prices have fallen. Cash flow based valuations are less attractive due to large capital expenditures, however the latter are coming down and will continue to do so as long oil prices remain low. Valuations across the smaller exploration companies are very distressed indeed, with many now trading at large discounts to asset value.
So we have very poor past performance and what appear to be very low market expectations as to the future – definitely a promising start.
Now onto the hard part. How can we determine whether these low expectations are being driven by an irrational fear or in fact justified by a new harsh reality?
To answer this question, we first need to understand each side of the argument when it comes to what drives the oil price.
On one side we have the “peak oil” school. According to this theory, the world is running out of oil. Having searched every corner of the globe we have found all the cheap sources of supply. Whilst there are still low cost reserves in the Middle East countries, production levels will never be high enough from these sources alone to satisfy growing global demand. Incremental supply therefore has to come from the higher cost sources, which in turn requires a high (and rising) oil price in order to incentivise investment. The peak oil school was firmly in the ascendency back in the mid 2000’s and in the years following the financial crisis when oil prices did indeed appear to be on ever upward trend.
One the other side are what I term the “technology optimists”. Capitalist forces of supply and demand combined with human ingenuity mean that in the long-run oil prices can be expected to be at best flat and perhaps even fall in real (inflation adjusted) terms. A key tenet of this view is that there is no shortage of oil in the world. It is simply a question of developing the right technologies to access it. No surprise that the technology optimists are in the driving seat today, with the relatively new technology of shale fracking being one of the key reasons for the current oil market over-supply. Technology optimists love to put up long-term charts of the oil price in real (inflation adjusted) terms – like this one, where, depending on your choice of start date, it is easy to show a flat or declining long-run trend.
I regard both of these mental models as examples of “new era” thinking. They are overly simplistic and I find that their followers often ignore contradicting evidence. In recent years, the peak oilers seemed unable to explain how all the investment in new oil extraction technologies was not likely at some point to lead to lower costs of production. But equally I find that the technology optimists of today are unable to provide a sensible rationale at to how the oil market is going to balance over the long-term at current oil price levels. Just because the long-run average real oil price is lower than the $40-45 per barrel level we are at today does not constitute sensible grounds for using it as a forecast.
So how can we formulate a long-term view of where the oil price might settle? A far more sensible approach, in my view, is to take the marginal cost of new supply as an anchor for the likely long-term oil price, whilst recognising that over shorter term periods the price can move significantly below or above this driven by factors such as short term cash costs of production, inventory accumulation or depletion, levels of spare capacity and speculative or trading activity.
Estimates of the current marginal cost of production vary depending on who you ask, but it is pretty difficult not to come to an answer significantly above the current oil price. The chart below from Bernstein shows the oil price as a percentage of their estimate of marginal cost (a reading of 1.00 indicates a price equal to the marginal cost). It also shows the prediction for the market clearing price based on their own model, which attempts to adjust for some of the short term factors highlighted in the previous paragraph. The model has been reasonably accurate, outside of extreme situations and, as expected, the actual oil price has shown a tendency to fluctuate around the 1.00 level. With the price today some 40-50% below marginal cost, oil prices need to go up and costs need to come down in order to bring the market back into a long-term balance.
Behaviourally, when I read the investment and media commentary on oil, I do find evidence that irrational fear may now be percolating through the markets. Short term factors appear to be getting an unusually large amount of attention. For example, the Iranian nuclear deal is seen as being a huge negative for the oil price because it means more supply, despite the fact that the amount of new supply expected (500 thousand extra barrels per day) is barely half a year’s incremental growth in global demand. This would hardly have been continued front page news when the oil price was $100 plus. Rarely do I see any mention of the fact that most of the OPEC countries are already operating close to maximum capacity, suggesting downside rather than upside risk to supply.
Looking at investment commentary on individual companies I also find an unusually high focus on potential short term downside risks. This is most obvious amongst the oil exploration and production companies where all the focus is now on near term cash flows and balance sheets, with any future development or exploration assets heavily discounted even when the assets are economically viable at current oil prices.
Finally the fall in the oil price is part of a wider collapse in the entire commodity complex which has built up over the past decade and half on the back of other “new era” theories besides peak oil. The “stronger for longer” theory of Chinese growth led to a huge growth in commodities as an investment class. Specialist commodity funds were launched and mainstream funds allocated more and more of their assets to commodities in order to diversify their returns. That much of this money is now exiting must surely be putting more downward pressure on commodity prices, including oil.
In summary, my assessment is that fear is likely playing some role in driving down oil prices and the share prices of oil exposed companies. I believe the combination of falling prices and excessive focus on short term downside risks may be creating a classic downward price-to-to price feedback mechanism. Yet long-term supply and demand suggest a combination of higher oil prices and lower costs are needed to clear the market once a new equilibrium is found. This, combined with the now distressed valuations across the sector, suggest that oil companies should be an interesting place to look for contrarian investment ideas. In the next post, I’ll take a more detailed look at the different investment opportunities within the oil and gas sector.
1. This is no recommendation to buy or sell any particular security.
2. BP Statistical Review of World Energy, 2014. Bloomberg, August 2015.
3. Bloomberg, August 2015