June 02, 2017

DNCA's weekly market outlook by Igor de Maack

Management comment

Both the announcement by Donald Trump of the US withdrawal from the Paris agreement and a temporary petrol shortage in the Paris region following industrial action, provide strong grounds for asking legitimate questions regarding the oil sector and more generally the energy industry, which are crucial for the economy and for the stock market. The oil price fell to below USD 47 per barrel in reaction to the US decision, undermining the consensus scenario predicting a progressive rally in the price of crude towards USD 60. A broad-ranging debate is beginning to animate the financial community regarding the impact of a durably low oil price on returns on capital employed in this sector.

Will the forward oil price be durably impacted by aggressive shale gas & oil production, which represents a growing proportion of profitability among US companies? Will OPEC and Russia agree upon and respect further collective output reduction agreements? What will be the cost and the market share of renewable energies solutions? Can gas (particularly LNG) delay the peak in oil demand expected during the 2030s and ensure that this sector creates further value? Will the rise of electric vehicles, representing an estimated 10% of the market over the next decades, and energy efficiency in this segment mean the end of classic hydrocarbon fuels?  Will Tesla manage to meet its production target of 500,000 vehicles per year? It would be presumptuous to attempt to answer all of these questions in just a few lines. Furthermore, there are probably several hypotheses to explore, rather than one single answer. The sector, which is currently trading on a 2018 PE multiple of 13.3x and yielding 5.4% net in 2017 in Europe, is inevitably attracting value investors and is nonetheless already partially pricing-in these risks, but to what extent? The oil majors have always had to overinvest in long-term projects, which are blighted by uncertain profitability given the volatility in the price of oil which is influenced by short-term cycles. These groups will have to rethink their business models by diversifying into other forms of energy, adopting vertical integration and bolting-on growth.

Major productivity gains have already been achieved and a more mature capex approach to over-complex projects seems to have been adopted. In short, the oil majors, representing the industry which has dominated modern capitalism for over a century in terms of its scale and market cap, will have to rethink their capital allocation strategy, just like investors who are now obliged to partially reallocate their savings towards new more reactive solutions generating higher returns than plain vanilla bond investments.

Igor de Maack, Fund manager and spokesperson at DNCA. This article was finalised in June 2nd, 2017.

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Both the announcement by Donald Trump of the US withdrawal from the Paris agreement and a temporary petrol shortage in the Paris region following industrial action, provide strong grounds for asking legitimate questions regarding the oil sector and more generally the energy industry, which are crucial for the economy and for the stock market....
2017-06-02