In this short review, we will explain our investment strategy for each of the five segments that make up the oil and gas sector and form part of the MSCI Energy Index. Our approach at RC Global Funds Management aims to capture opportunities for growth and income that offers the most attractive risk-reward without having to take a view of the oil price itself, which is very hard to predict.
Oil & Gas Service segment- High risk and too early to buy
We are least keen on this group. Why? Any company that provides support, drilling and well completion services to oil and gas producers be they the national oil companies (NOC), international majors like Shell or Exxon (IOC) or the independents like ConocoPhillips, will be hit hardest. All these companies are rushing to cut their capital spending.
In its heyday, Schlumberger and peer like Halliburton were coveted oil and gas companies. From the dawn of the shale revolution in about 2005 to just before the oil crash of 2014, Schlumberger was a star performer, supplying services and technologies to shale plays across America. Schlumberger was instrumental in developing, servicing, and supporting many of the onshore and offshore oil and gas fields that led to the U.S. becoming the leading oil-and gas-producing country in the world. Since 2014, Schlumberger has been struggling to succeed in a lower oil price environment, and its stock has fallen over 80% and we believe it is still to be avoided. It would be the best stock to own in this group one day!
Oil and Gas Producers – Highly selective
This second group which explores and produce oil and gas was badly hit as well in March-April with plunging oil prices. We are cautious yet more positive here than the services group, but one needs to be highly selective. Similar to what we look for in other sectors, we believe balance sheet comes first, where these producers operate, management track record and their shareholder base can make a difference too. If companies can keep their costs down and be able to breakeven at lower oil prices, they will be the survivors. On the otherhand, we can expect more bankruptcies’ in the high-cost and highly leverage shale producers in the US. There will likely be consolidation among the shale producers as the stronger players will acquire the weak players or buy their better assets.
Woodside Petroleum Australia (WPL) is one of the strongest in this group, given its low net debt compared to its EBITDA at 0.8X. Another feature of the company is that as
essentially an LNG (accounting for 75% of total production) company with revenue tied up in long-term contracts for exports to Japan, China and Korea. It is more insulated from
the short-term plunge in oil price, even though there are oil price linked clauses in those contracts. Thus, any prolonged low oil price would ultimately impact its earnings. The
company is free cash flow breakeven at US$26 per barrel. Woodside has recently reduced its capital expenditure guidance by ~60% to US$1.7-1.9bn for CY20 as it cuts back on all non-committed activities and defers growth expansion projects. The company is also targeting a US$100m reduction in operating expenditure. Exploration guidance was reduced by 50% to US$75m. The company has US$4.9bn in cash and ample liquidity of US$7.9bn. Its debt repayment schedule is largely weighted to the 2H of the decade with debt repayment commitments in CY20 a mere US$100m while there is a larger US$800m repayment due in CY21. Currently providing 6.2% dividend yield, we would expect a smaller upcoming interim dividend.
Other than this core holding, we had invested in other stocks in this volatile group during the recent lows but taken profits, and they include top quality names such as CNOOC of China and ConocoPhillips of the US.
Oil Refiners and Marketing Companies – Buying for recovery
The third group is the downstream side of the oil and gas business, which comprises of refinery and marketing companies. These companies focus on refining specific products from crude oil and gas and, then market these products through their distribution channels. These companies generally have extensive marketing and sales channels, points-of-delivery networks, pipelines, and refineries to grow their market reach.
We preferred this group over the producers and service segments. As their margins increases when the oil and gas prices are lower providing insulation. They are still
affected by reduced demand for their products, such as, petroleum, but they are in a stronger position for a more rapid return when economic activity starts recover from global lockdowns.
Phillips 66 US is our preferred holding and the most diversified in this group. It does not produce any oil, since the 2012 split that made it a stand-alone refining, marketing, pipeline, and petrochemicals business -- in short, everything other than the upstream side of the oil business. The company buys the oil that it uses, and that should help insulate it from some (not all, but some) of the impact of falling oil prices in its refining operation. It still feels the severe pinch from falling demand for gasoline (less people driving) and jet fuel (fewer planes flying). Still, its natural gas businesses, its pipelines, and its petrochemicals manufacturing should prove much stronger and more resilient than its oil related segments.
It has a management team that is proven excellent at navigating energy cycles, making sure the company has the cash it needs to ride out a prolonged downturn in fuel demand
and consistently paid growing dividends. With about $5 billion in cash and a low-cost credit facility, it will have no problem riding out the worst of things. Phillips 66 has the benefits of being an integrated major, without the albatross of being an oil producer, it is the largest independent refiner globally. With a dividend yield of 4.7% and no cut expected, it meets our risk-reward criteria.
Midstream Companies – Hunting for opportunities, but screening debt coverage
These are companies that transport the produced oil and gas via pipelines, have facilities like storage, processing plants also pipelines to transport the various processed or refined products and terminals like jetty for export to other markets overseas.
Companies in this segment operate in a very similar way to the “Utilities business model” with contracted volumes, so they are not affected by the fluctuation of the underlying commodities prices be it oil or gas or the processed products. Partly, as a result, many do carry quite high levels of debt.
Magellan Midstream Partners US is our current favourite in this group. Despite the downturn in the oil industry, the company's biggest segment (39% of rev) -refined products delivered solid results overall. Revenue increased by $4.7 million because of higher transportation volumes and rates, helped in part by the recent completion of the East Houston-to-Hearne pipeline segment. These positives offset lower demand caused by the COVID-19 outbreak as well as reduced drilling activities as a result of lower oil prices.
Revenue in the company's crude oil segment (20% of rev), on the other hand, declined by $6.5 million. That was primarily due to fewer shipments on the Longhorn pipeline as a
result of the recent completion of competing pipelines. The company also sold a 10% interest in the Saddlehorn pipeline in February, which affected earnings.
In anticipation of the impact of falling demand for refined products on its 2020 financial results, the company estimated it should still be able to generate between $1 billion and $1.075 billion of cash this year. That's enough money to cover its payout by about 1.1 to 1.15 times. Magellan also anticipates that it will generate about $75 million to $150 million in free cash flow after paying its dividend, which gives it a head start on funding its $400 million expansion program. Add in cash from recently completed asset sales and the borrowing capacity of its top-tier balance sheet, and Magellan can easily make ends meet while mainlining one of the lower leverage profiles and highest credit rating among its peers. On current estimate, the company is on a very reliable 9.4% dividend yield and still able to fund growth expansion projects.
Another winner is Royal Vopak of Netherland which boosts a top 3 in oil storage capacity globally, given the recent tightness in oil storage due to over-production Vopak is in an enviable position to fully capitalise on it.
Integrated Energy or Majors - Big and diversified is the best position for recovery
This group, as the name implies, operates using the “Integrated Model” which covers both the production side (upstream) and refining and chemical units (downstream). Also, many have substantial activities on the LNG activities and operate gas liquefaction plants with export facilities sometimes even ownerships in the LNG tankers. The biggest
integrated names include the biggest five in the Western World called the Super-Majors (Exxon, Chevron, Shell, BP and Total) and others in the Emerging Markets of which PetroChina and Sinopec (China Petroleum & Chemical) are the two largest. We believe this group overall represent the best values in the Energy Sector.
- These bigger integrated companies with stronger balance sheets are more likely to weather the current industry conditions than smaller, companies both within this group or the specialists in the previous four groups.
- Their integrated model means quite often one part of the business may be doing better than the other part. Offering a partial hedge when the oil price is low – the downstream elements like refining and chemical tend to do better with lower input costs.
- Those that have sizeable LNG business also may be able to withstand lower oil price as LNG mostly rely on long-term contracts.
For the time being the less exposure a company has to U.S. shale production, the better as the international benchmark Brent is less impacted by the extremely low prices recently seen in the US which is using the WTI due to the congestion issue.
All the oil majors which should be more defensive this round have not been spared with a share price that's fallen 23-43% YTD. As such, their dividends are currently yielding a juicy 4-10%. Some have reduced their dividends but none have cut out entirely as seen in many other sectors.
Total of France stands out in this group. It has a strong balance sheet that includes a $27.4 billion cash hoard and a high credit rating of Aa3/AA-, which should allow it the financial flexibility to maintain that payout. It has trimmed its 2020 capex by 20%. As a result, the stock offers an attractive 8% dividend yield, and there is no indication of any cut in the current year.
Also, Total has the least exposure to US oil production of any of the oil majors, just 10% to the entire American continent.
||Percentage of 2019 Liquids Production from U.S.
||10% (north and South America)
We believe the integrated group should be the backbone for investment allocation in the oil and gas sector. Because of their strong balance sheets, diversified operations, and can leverage on market consolidation with oil prices at historic lows. In selecting individual stocks, where we are seeing dividend yields ranging from 5% to 10.5%, we are using the investment criterion of balance sheet first, where they operate, management track record, shareholder base, and positioning with global mega-trends. The integrated group represents 44% of the oil and gas holdings. We have supplemented these holdings with the most reliable names from oil & gas producers, refiners & marketing as well as
midstream companies that will benefit from a recovery in demand for oil and gas.
We will add further positions in these segments, including services, when we see additional indicators of sustainable economic growth or market consolidation in these
sectors. We believe our approach provides a robust portfolio to withstand the volatility of the oil and gas prices to perform well when oil and gas prices are low but participate in the upside when the demand for oil and gas returns.
Currently, Infra-Energy fund has a 23% holding in the oil and gas sectors with broken up into the flowing segments:
|Oil Refiners & Marketing
|Oil and Gas Producers
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As a Special Education teacher this resonates so well with me. Fighting with gen ed teachers to flatten for the students with learning disabilities. It also confirms some things for me in my writing.
Love it Dave! We're all about keeping it up.
Since our attention spans seem to be shrinking by the day — keeping it simple is more important than ever.
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