Five reasons to consider the energy sector

August 26, 2021

12:30 am

Despite rebounding in the first quarter of 2021, the energy sector is one of the worst performing sectors in the last year (and for several years). This seems puzzling given that it is the sector with the fastest earnings growth and the most positive earnings revisions in 2021. It seems that many investors are not willing to consider the sector, but we believe there are five reasons why they should take another look.

  1. Forced Selling Can Lead to Irrational Behaviour

Since thousands of investors have access to huge amounts of data, one can assume that their collective wisdom leads to assets being reasonably fairly priced most of the time. Where this does not apply is when investors become forced buyers (pension funds being forced to buy government bonds with negative real yields) or forced sellers as is currently the case with the energy sector. In their rush to virtue signal their green credentials, many fund managers have excluded sectors such as energy and mining from their investable universe. We have discussed before why we think this makes no sense here but it also leads to the situation where investors become forced sellers of these stocks irrespective of how low the valuation is and potentially create an opportunity for others to exploit.

  1. Out of Favour[1]

As an indicator of how out of favour the energy sector is, consider that in 1980, it made up 30% of the S&P500 index whereas today it represents less than 3%. To put that in context, the Technology sector is now 28% of the S&P500 and both Apple and Microsoft represent more than 5% of the index.

 

  1. Fundamentals

The irony of the energy sector being out of favour is that it comes at a time when the fundamentals are looking very promising. In response to falling energy prices as well as environmental pressure, energy companies have slashed their capital expenditure, for instance the chart below shows that the 43 largest listed producers have cut their exploration & production capital expenditure by two-thirds. Some believe that as Covid subsides and world economies re-open, there may be insufficient production to meet rising energy

[1] Source: Bloomberg, 9th August 2021

Source: JP Morgan, 26 April 2020

*Data comprises the 43 largest listed producers (by liquids production) globally, excluding Aramco

 

     4. Cheap Inflation Hedge

Whilst central banks continue to assure markets that rising inflation is transitory, investors need to consider the possibility that they could be wrong (or that they have a vested interest in this claim). With the Federal Reserve having expanded their balance sheet by $4 trillion in just six months last year (the same amount as occurred between 2008-2018) and the US government running a deficit amounting to the total of the cumulative deficits in all the recessions from 1980 to 2007, the ingredients for an increase in inflation are certainly there.

Source: Bloomberg, as at 30 June 2021

Historically energy stocks have performed well during periods of rising inflation and given the low starting valuations of them today, one can make the case that they offer the possibility of a cheap inflation hedge.

 

This argument can be extended to more broadly to commodity prices which are at their lowest point relative to the S&P500 since 1969 which preceded one of the best decades for commodities ever.

Source: Bloomberg, as at 30 June 2021

     5.Low Valuations

Buying stocks with low starting valuations has gone out of favour in recent years but we still believe that this holds as one of the best guide to future returns. If we use BP as an example, management have guided that at the current oil price of $70, the company  would produce free cash flow per share of 73 cents which at the current USD share price of 422 cents, equates to a 17% free cash flow yield (and note this is AFTER all the capex required to transition to renewables production). At $60/bbl Brent, the company expects to be able to deliver buybacks of around $1.0bn per quarter and have capacity for an annual increase in the dividend per ordinary share of around 4%, through 2025. BP’s plans imply ~10% of market cap returned to shareholders split about equally via a ~5% dividend yield and an annual cut of ~5% of its share count meaning that BP could return >55% of its market cap across 2021-25 back to shareholders.

 

The chart below shows that the dynamics highlighted above apply more broadly across the European oil majors but particularly illustrates the scope for dividend increases given the very high dividend cover afforded from the current cash generation.

Source: Company reports, Bloomberg & Bernstein analysis estimates. 

Forecasts and estimates are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. The forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so.

 

With many indicators suggesting that the US equity market is currently more expensive than at any time in history, the energy sector would appear to have a lot of positive attributes that investors should consider.

 

Unless otherwise stated, all opinions within this document are those of the RWC UK Value & Income team, as at 27th August 2021. 

In case you missed it…

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.

This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.

RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.

Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.

The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.

AIFMD and Distribution in the European Economic Area (“EEA”)

The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.

In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).

Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland

The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) FIRST INDEPENDENT FUND SERVICES LTD, Klausstrasse 33, CH-8008 Zurich. Swiss Paying Agent: Helvetische Bank AG, Seefeldstrasse 215, CH-8008 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

Ready to start talking?