Energy investing right now: pros and cons

Energy investing can be a tricky game. Rock bottom oil prices at the start of this year rekindled enthusiasm in the major oil companies and those who ignored the naysayers and bought when a barrel dipped below US$30 looked to be vindicated in June as prices crested US$50.

In the tempestuous world of black gold, however, sentiment can swing wildly, taking both equity and commodity prices with it. A barrel of oil is now back down around US$42 and the question arises – is this another buying opportunity or a sign of darker days to come?

What is the best way to make money out of oil?

The pros

It’s worth noting that oil prices are still substantially higher than they were in late January and I think we’ve come off those very low levels. The capital expenditure cuts we’ve seen over the past 18 months are finally impacting supply in a meaningful way. Expectations for future years’ supply are definitely lower than they have been.

The quick rise up to US$50 a barrel was in large part based on temporary outages, such as the Canadian wildfires and disruptions in Nigeria. Now that these scenarios have ‘normalised’, the oil price may resume a more gradual upward trajectory based on a rebalancing of supply and demand.

Five-year forward crude oil is at nearly US$60 a barrel and it is futures, not spot prices, to which the outlook for energy equities is more closely linked. This explains why we sometimes see stability in energy equities even while oil prices appear to be falling.

What’s more, one of the benefits of investing in the large, global oil producers—as opposed to buying the commodity itself through some sort of exchange traded tracker—has always been that these companies are not, in fact, directly correlated to the oil price.

Most of the majors run both upstream (extracting the oil from the ground) and downstream (refining the oil and turning it into consumable products like gasoline and kerosene) operations. This means that while their upstream businesses definitely struggle when oil prices fall, their downstream businesses can take advantage of these same lower prices, reducing input costs and boosting margins.

The cons

On the flip side of the energy equation, however, we’re now starting to see supply issues downstream. There is a glut of petroleum, which is making markets nervous. Margins are falling and with the peak of the US driving season almost behind us (summer in America marks an annual increase in demand as families en masse take driving holidays), it’s difficult to see what might help refineries to clear out their stock in the short term.

The biggest names in the business, including Shell, Exxon, BP and Chevron, reported half year results in the last week of July and all posted either substantial falls in profits versus the prior corresponding period, or losses. In statements to shareholders, many executives spoke of the challenges they were now facing on the downstream side.

Questions have long surrounded these companies regarding their dividend sustainability and these kinds of results obviously do nothing to reassure.

The buy?

That said, I’m personally inclined to take a more positive view. Energy equities are up 22% in sterling terms in the year-to-date1 (admittedly, like all international investments, given quite a boost by our falling currency). Even in US dollars they’ve risen 9%2.

Following the oil price falls from June highs and the major companies’ poor earnings updates, sentiment has gotten depressed again – particularly in the past week. Yet energy over the long term tends to be a strong performer.

Despite massive dips, global energy equities are up 220% in sterling terms over the past 20 years3. Global equities overall have managed 167% by comparison4. So there is definitely an argument to make for a temporary dip in prices providing a buying opportunity.

Nothing ever goes up in a straight line, but I’m still happy parking some of my savings in the sector. For investors who also want to ‘take a punt’, the Guinness Global Energy fund is on our watch list.

¹ FE Analytics, MSCI World Energy, price in GBP, 31/12/2015–01/08/2016
²FE Analytics, MSCI World Energy, price in USD, 31/12/2015–01/08/2016
³FE Analytics, MSCI World Energy, price in GBP, 01/08/1996–01/08/2016
⁴FE Analytics, MSCI World, price in GBP, 01/08/1996–01/08/2016