Energy equities starting to look interesting

Energy sector valuations have already priced in a more bearish outlook for oil despite some supports in the nearterm

Energy equities have lagged the recovery in oil prices
While oil prices corrected 13% in March and have since risen 8% to nearly their pre-correction levels, the interesting thing is that oil-related equities have lagged and have risen only 2% versus global equities.

Some near-term supports for the oil price
We are not bullish on the oil price – we continue to see it range bound in the medium-term. Compliance issues among OPEC are likely to cap the upside, while US shale production could exert downside pressures. Nevertheless, there are some counter-balancing supports in the near-term:
First, Oil positioning looks more balanced now. Since we pointed out that speculative long positions in oil were at an extreme at the end of February, they have since come down and look more balanced, removing some downside risk for further forced selling.

Second, we are entering a seasonally favourable time of the year for oil prices – on average over the last 10 years, the oil price has tended to rise from March to August. The closure of refiners for maintenance during this period and the start of the ‘driving season’ in the US tend to be the main supports.

Third, global demand conditions continue to look robust even in the face of rising supply risks from shale and OPEC producers.

Energy sector valuations have already priced in a more bearish outlook for oil
Based on a range of valuation metrics, energy equities have already priced in a lower-for-longer outlook for oil. The Price-to-Book and Dividend Yield ratios relative to the wider market are both trading one standard deviation cheap to their long-term average. The Energy sector has the highest forecasted dividend yield (3.6%) among cyclical sectors and higher than the overall market (2.6%).

Valuations compared to other reflationary beneficiaries such as Materials and Industrials are close to an all-time extreme. The MSCI World Energy sector is trading on a 20% discount to the Materials sector and 40% to Industrials on Price-to-Book.
Energy should benefit if the rotation in value / reflationary beneficiaries continues.
The sector looks less attractive on P/E as earnings are still recovering. However, on a 3-year outlook, the Energy Sector is forecasted have the strongest EPS growth of any sector on consensus projections.

Energy Sector balance sheets healthier now
What is worthy to note is that the Energy sector credit risk is much lower than 3 years ago: the recent dip in oil prices has not caused high yield energy spreads to blow out because global oil companies have been through a period of unprecedented cost and capex cuts. According to IHS Markit, upstream capital expenditure and operational costs in North America have fallen by 50% in 2015 and 35% in 2016, their fastest rate for the last 30 years. This has helped the sector’s projected FCF yield to move back into positive territory for the first time in three years and should help solidify companies’ dividend pay-out policies going forward.

What are the risks?
One of the biggest risks to oil prices in the medium-term is deteriorating compliance among OPEC members. The cartel is only 83% of the way to cutting the 1.2mn barrels proposed last year. Extending the deal could be difficult given that non-OPEC countries are doing far worse on compliance. We should get an update at the next OPEC meeting on 25th May.

James Butterfill – Head of Research and Investment Strategy – ETF Securities