Friday, November 8th, 2019

Is Energy Un-Investable?

In mid-September, there was a week when the Energy sector was ranked #10 in all our regional equity sector models, apart from China, where it was ranked #9. The simple average of all the models is currently -72% relative to benchmark, having reached -75% in late October. This is a truly terrible result. It’s not as bad as the -90% underweight during the oil-price slump in 2014, but it is on a par with the other major sell-offs in 1997 and 2006.

There are very few occasions when any sector gets this low on a global basis. Examples are the Financials sector in November 2007 and December 2008 or Technology and Telecom in 2000/01. When sector weights do get this low, there is normally a clear and present crisis which threatens the viability of the underlying business. The driving force behind Energy’s underperformance in the three previous episodes was a collapse in the oil-price, but it doesn’t explain the current weakness. The total return from oil futures has oscillated in a narrow range since late 2015 – certainly by comparison with its long-term history.

The US industry is also having a tough time in the fixed income markets. The sector is at maximum underweight in the High Yield model and -88% underweight in Investment Grade. This is a revulsion reaction, as bad as the levels reached in 2014. It is no secret that many of the fracking companies have weak balance sheets and insufficient cashflows at current oil prices to meet all of their obligations as they fall due. For instance, Chesapeake Energy recently warned that it might not be able to continue as a going concern. However. it may be an over-reaction to shun investment grade issues on the same basis and the weakness in US credit does not really explain the underperformance of the sector in non-US equity markets.

Whenever we discuss the Energy sector with clients, we acknowledge the increasing influence of the ESG agenda and government regulation/taxation. Some asset owners have already set a timeframe for reducing or eliminating their exposure to fossil fuels. Others may follow their example, but it is difficult to put hard numbers on how much capital might be withdrawn and what effect this would have. Most investors also expect stricter emissions controls in Europe, particularly in urban areas, as well as new forms of taxation, such as carbon pricing. Above all, the electrification of the transport industry by 2030-40 is likely to become a policy priority for most industrialised countries in the near future. All of this makes the oil industry look increasingly like the tobacco industry 20-30 years ago.

Despite all this, we would be really surprised if the Energy sector didn’t recover to a global overweight at some stage within the next two years. There comes a time when all the bad news is in the price, when the last ESG-inspired investor has sold, when the distressed high yield debt has been restructured or written off, and when falling share prices lead to more attractive dividend yields in a yield-starved age. One of the features of the tobacco industry was the sheer amount of cash it could generate once it was no longer trying to grow its business. Several waves of M&A activity also generated premiums for patient investors. There is an old saying in the industry that the solution to low oil prices is low oil prices. Nothing is forever.  The cycle will turn, just as it did in 1998, 2007 and 2015.

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