By Tawhid Ali, Jeremy Taylor
As the oil price recovered from multiyear lows, shares of energy companies rebounded. But it's not too late to invest. We think some large integrated companies can still improve efficiency.
Oil prices have been resilient in recent months. Even after the Brexit shock, Brent crude was hovering at around US$50 a barrel at quarter-end, after rebounding from a trough of below US$28 in January. Oil stocks have closely tracked these moves, but remain attractively valued. We expect the gradual recovery to continue despite several obstacles. But even if the recovery takes longer than we currently anticipate, the markets may be underestimating the capacity for adaptation and cost savings that the big integrated oil companies have developed during the oil price collapse.
Revisiting The Case For Higher Oil Prices
Since oil prices began to fall, we've made the case for higher oil prices. Two major developing trends have shaped our view: declines in exploration spending and cuts to investment in long-term projects.
As regards the first one, a steep fall in investment in US shale oil in 2015 has already led to a decline in production this year. Exploration costs tend to respond to changes in the oil price, as the high correlation in the display below shows. And as oil prices fall, the most expensive projects are the first ones to be culled. While there is a bit of a time lag, the level of investment in major projects is catching up quickly with the stark reality of today's lower oil price environment. This has contributed to a reduction in global oversupply, which we expect to disappear completely within the coming months.
Long-term projects are also being cut aggressively. Investment decisions on major projects are already down by 80% from the peak. We expect this decline to progressively bite into non-OPEC production outside the US from 2017 onwards.
Are Dividends At Risk?
Yet investors are still anxious. Until recently, dividend yields for European oil majors were trading near historic highs, leading to concerns about their ability to maintain payouts. The rally in oil prices in recent months has begun to soothe investors' fears about dividends, but yields still remain high, indicating that skepticism remains.
Additionally, we think investors do not fully appreciate the ability of oil companies to structurally reduce their operating costs and investment intensity if oil prices stay low. If these costs are driven down, more cash flow will be able to fund the dividends.
There are several ways for integrated oil companies to reduce costs, even after slashing the most capital-intensive exploration projects. Today, oil majors have considerable power to reduce prices charged by suppliers, who are desperately competing for work in an environment of reduced demand. Everything from equipment prices to labor cost is now falling rapidly.
Which companies are best placed to thrive? Well-established, soundly financed and broadly diversified oil titans make good candidates, in our view. Identify those with the experience and skilled management to successfully lead the way, by improving efficiency and cutting costs, to position for a potential recovery. And focus on companies that have proved their mettle in past downturns when their ruthless cost-cutting enabled them to outperform the broader market for many years.
As the oil price recovery unfolds, selectivity remains paramount. The energy sector is still littered with stumbling blocks that could impede a sustained rebound, such as a slowdown in the recent strong growth in driving by emerging-market consumers, particularly in China and India. But investors with a long-term perspective, who diligently select the most resilient names in this volatile sector, should be rewarded for cautiously reentering at these attractive valuation levels.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.
Tawhid Ali - Portfolio Manager, Global and International Value Equities; Chief Investment Officer, European Value Equities
Jeremy Taylor - Senior Research Analyst