In my previous post I suggested the oil sector may now be an excellent place to look for undervalued shares. In this post I will look at different opportunities within the sector1. I break them into three broad categories: 1) Integrated oil; 2) Exploration and production (E&P); 3) Supply chain.
1) Integrated oil refers to the large oil companies, such as BP and Shell. They are called “integrated” because they own both production and refining assets. This diversification means their revenue and profit streams are usually more stable than some of the smaller more focussed companies in the industry. When oil prices fall, refining profits tend to rise whilst production profits fall, and vice-versa when oil prices rise.
Integrated oil companies intrigue me because they are almost universally hated by the investment community. You can see this by looking at valuation. The absolute and relative price-to-book ratios are at or close to record lows. This is true even after assuming asset write-downs similar to previous oil down-cycles. You can also see it by reading what people say about them. The commentary is a constant barrage of negativity – “poor management”, “poor capital allocation”, “lack of free cash flow” etc. I share many of these concerns, however they mostly relate to things that have already happened, rather than what might happen in the future. And uncovering stock market value is much more about the latter than the former.
So what might happen in the future? In my view, a very important change has taken place in the way integrated oil companies are managed. In the past, there was an ill-disciplined approach to costs and capital expenditure, which were allowed to spiral out of control as the companies sought to grow production. The management teams were able to hide behind the high oil price for a while but this is clearly no longer the case. As a result, they are now forcing through big cost reductions in order to make their business models work at lower oil prices. Much of the pain will have to be taken by the supply / service companies. Given the overcapacity in many of these areas there is little these companies can do to mitigate this trend.
I have no idea where the oil price will be tomorrow or next week, but I am fairly confident that the current combination of oil price and costs is not sustainable over the long-term. Ultimately the economics of the industry have to be such that new capital investment is incentivised because demand is still growing and existing fields will continue to deplete. Therefore some combination of lower costs and higher oil prices seems likely. Once this happens I expect the share prices and valuation of the integrated oil companies to be significantly higher than where they are today.
2) If integrated oil is hated then the situation facing its little brother – the E&P sector – is one of disgust and despair. Disgust with the companies and their failure to manage the cycle appropriately. Despair at the continual underperformance of the sector, not just recently but over the past 1, 3 and 5 years.
Most share prices across the sector are down at least 50% over the past year, with some down much more than this. This terrible performance reflects genuine fundamental issues. E&P companies are typically upstream businesses and much less diversified than the integrated oil companies, making them more exposed to falls in the oil prices. Many also have balance sheets designed for $80-90 oil rather than $50, which in extreme cases brings survival of the equity itself into doubt.
Yet despite these issues, I currently see some fantastic value within this sector. I believe this value stems from stock market myopia. The collapse in the oil price and the balance sheet issues across the sector have created an environment of fear. The result is that the stock market is heavily discounting assets where the value is based on cash flows 1-2+ years out, even when there is little risk to these cash flows. Moreover some E&P companies have strong balance sheet positions meaning they can withstand low oil prices for a long-time before having any significant problems. Faroe Petroleum is excellent example. The company has nearly 50% of its market capitalisation in cash, it has ongoing production that can fund its operations and its exploration, and it has exploration prospects that are very material relative to its current size. Despite these attractions, the shares are trading at over 40% discount to our estimate of the company’s asset value. But Faroe is far from an isolated example. There are many similar situations within the sector.
3) Supply chain refers to any company or industry that supplies products or services into the oil industry. This is a diverse group of companies including contractors, consultants and engineers. Unsurprisingly share prices and valuations in these areas of the market have also been hit hard as investor expectations have deteriorated. Although I do see some good value in certain companies, I am generally much more cautious here. My main worry is that many of the companies in this area have just had a bumper decade that saw them dramatically increase revenues and their profit margins. Looking forward, the much more cost disciplined approach of the integrated oil companies – who are the main customer for most of these companies – means that profit margins are likely to come back down, quite possibly back to where they were before the oil price boom began in the early 2000s. And when I look at the equity valuations, in many cases they are not yet priced for this outcome.
1. This is no recommendation to buy or sell any particular security