Increasing demand for oil from markets such as China is helping make the outlook for oil and gas companies better than it has been for some time
The global energy sector has come through the recent economic downturn by carefully managing the oil price but increasing demand is now reinforcing supply-side factors to make the outlook for oil and gas stocks brighter than it has been for some time.
Poppy Buxton, who, along with Robin Batchelor, manages the Merrill Lynch World Energy Fund, feels the energy sector is finally joining the natural resources party that has been in full swing for at least two years. While gold and mining stocks have been the belles of the ball, energy has been left on the sidelines, with investors convinced the oil price must inevitably fall from its current level of around US$37 per barrel.
Not so, says Buxton. The Organisation of Petroleum Exporting Countries (Opec), which controls one third of global oil production, has skilfully brought the industry through some tough years by controlling supply. Now those efforts are being reinforced by rising demand from the economic revival in the US, the world's largest oil consumer, and rapid growth in China.
"People think the oil price is so high but actually, it's not," Buxton notes. "Today, in real terms, the oil price is about half what it was in the early 1980s. Historically, oil has stayed at or above these levels for some time. It will always be cyclical but we are entering a period where prices might stay higher for longer. In the short to medium term, we can't see much that will bring the oil price down."
The US imports 55% of its oil needs and is actively adding to its strategic petroleum reserves, as are a number of other countries. China is the world's fastest growing consumer of oil, accounting for 7% of global demand. This year, it overtook Japan to become the second largest oil buyer after the US. Buxton comments: "While we do not pretend to be experts on China's economy, we would point to one fact: there are less cars per capital in China today than there were in the US in 1910."
Growth in global energy demand this year is set to hit its highest level since 1997 and there are other supply factors underpinning the brighter outlook. "There are always supply shocks, or events, but recently the effect on the market tends to last weeks or months rather than a few days," she adds. "Factors like political instability in Venezuela and the situation in Iraq are having a more sustained impact."
Although Opec's target oil price band is US$22-$28, the organisation is clearly comfortable with a higher price, especially as Saudi Arabia, one of Opec's most influential members, needs an oil price of around US$30 a barrel to run a balanced budget.
The two thirds of global oil production not in Opec's hands is controlled by oil 'majors' such as BP and Shell, and large one-time state enterprises such as the big Russian oil companies. Most players in this area of the market are experiencing supply constraints as they struggle to expand production.
"Their oil fields are often mature and production has peaked," Buxton comments. "Where oilfields have yet to be developed, like West Africa and the former Soviet Union, projects have been delayed and there are constraints to do with underdeveloped infrastructure. In Russia, for example, there is only so much pipeline to pump oil through. Investment is pouring in but these are multi-billion dollar projects that take years to realise. Russian production today, even with the new investment, is still well below where it was in Soviet times."
So over the past six months, the oil futures curve has steepened sharply because oil in general is becoming harder and more expensive to find and develop. But it seems investors have not yet spotted the opportunity; oil-related stocks are not pricing in the improved macroeconomic picture. "Stocks are priced for a much more pessimistic scenario than that offered by the spot and futures markets," says Buxton.
The way most investors have traditionally accessed the energy market is to buy the stocks of oil majors such as BP and Shell but following this strategy over recent years would have proved disappointing. "The days when you could buy these companies to benefit from the oil price are limited now," Buxton observes.
The furore surrounding Shell's recent restatement of oil reserves has focused investors on the figure for other companies and on the general problem of a diminishing resource. Chevron's three-year reserve replacement is estimated at around 97% and Exxon's at 96% but Total's is given as 106% and BP's, following its acquisition of TNK last year, is 122%.
Companies that are resource rich will become increasingly valuable but the best opportunities for investors are likely to be among the small and mid capitalisation companies more leveraged to the market and with a better opportunity set. One estimate suggests that for every US$1 increase in the oil price, oil majors can expect to add around 5% to their earnings per share figure but, for small and mid-cap firms, that could be considerably more.
"The energy sector today is all about being a good stock picker," Buxton says. "You have to know each company's assets and how it might benefit from any development. Does it have the reserves and how quickly and cheaply can it turn them into production? Companies like BP and Shell are not bad, they are just so big and had such great success in the 1960s and 1970s they are finding it difficult to sustain that pace of delivery."
Reserve-rich enterprises are increasingly going to make tasty acquisitions for the oil majors as they move to bolster their place in the market by buying what they need. Investors holding target companies are set for a bonanza.
The improving macroeconomic environment will underpin energy prices going forward and well-placed companies within the sector will be able to generate strong cashflow and better-than-expected returns. Valuations are reasonable and, because of the mismatch of perceptions, Buxton is confident of a good results season. "We expect a number of positive earnings surprises and that will mean the analysts start making upwards revisions," she says.
Brokers note that since 1998, oil stocks have been de-rated versus mining stocks by 40%, yet their relative earnings have more than doubled and the oil price has risen by 50% more than metals' prices. Investors draw different conclusions from such statistics but solid fundamentals, which the wider market has yet to acknowledge, underpin the sector.
For sector experts, there are a number of ways to play the opportunity. Buxton buys in the oil products market, which encompasses anything from diesel to jet fuel, engine lubricants to bitumen. "The dynamics in this area are slightly different," she notes. "While crude oil is a global market, refining and marketing are driven more by local supply and demand factors. The economics vary by region, as do the environmental considerations."
Among the oil products stocks she favours is SK Corp, a Korean refiner that has benefited from the general economic upturn in Asia. It has the right product mix and is undergoing a management overhaul after a spell with a poor corporate governance record. Buxton investigates not only companies that look for oil and gas but those with drilling, processing and transport expertise.
Another favoured stock is Suncor, which produces petroleum from the Athabasca oil sands deposit in Alberta, Canada. Suncor uses the most advanced technology to mine the sands for oil and has been able to cut production costs dramatically. Operating costs are running at around CAD10 a barrel but the company's market cap stands at the equivalent of less than CAD1 per barrel of reserves.
"If you have the right company with good assets and it can produce oil and gas inexpensively, it can be very exciting - companies can be making triple-digit returns," Buxton notes. "Most of the current energy coverage is bad news stories about Shell but there are also a whole lot of companies out there boosting reserves rather than cutting them."
