Oil price has crashed from high $100’s reached in 2007 to current price range between $40 and $50s. Following the crude oil prices bottoming post cost at below zero the pendulum between risk and reward looks to be leaning towards reward for long term investors.
Investors can play in the recovery oil prices either directly through owning crude oil futures, oil equities or oil & gas equity ETFs. We personally prefer investing in energy companies rather than the commodity it self or the passive indexing approach. We like owning equities due to rights to the ongoing cash flows and opportunity for capital and income growth over the long run as production and subsequent earnings improves.
Only the largest energy companies with bullet proof balance sheet will survive the current downturn. Even those with the strongest balance sheet going into the crisis are struggling but are outperforming shale producers which had even more leveraged balance sheets with no room to move.
Oil Stock ETF Performance
Our portfolio leans towards large cap energy companies due to the strong balance and ability to survive the downturn. Given where the current energy company stocks are trading at there is also a significant margin of safety until the prices and the economy recover.
Decline in medium oil production in the medium term is expected as the current overleveled players goes to bankruptcy. This will be supportive of oil prices in the near term.
We feel the bounce in oil prices this year is sustainable but it will be bumpy along the road as it is simply a matter of time before the shale producers run out of financing and cash. Investors in anticipation of the recovery will be paid by taking the risk today in energy company stocks.
Long term risks to energy company stocks
Once the oil market has stabilised then the focus for companies will shift back to growth. Growth either through increasing production competitively and also swallowing up the weaker players that are no long competitive to get ready for the next up cycle in oil price.
If you ask investors going long the oil sector what is the biggest risk to the sector in the long run most will answer climate change. It is for this reason some investors have been reducing oil exposure in their ETF portfolios.
We agree the transition from gas to electric vehicles will pose a long term risk to oil consumption. China has propelled oil demand over the last 2 decades and there are signs that oil demand in China has peaked. However we have always been an emerging markets bull. Whilst the transition of next group of countries from developing to developed economies will plug the gap from China and to an extent the US.
Which area of the energy sector do we like?
The energy sector spans a range of sub sectors with its own risk and return profiles. From oil services (onshore) to offshore drilling to exploration and production companies focusing just on shale, oil sands to conventional production.
We are most bullish on the LNG space because it will be the biggest beneficiary from the transition from coal to cleaner base energy consumption. LNG demand out of Asia particularly China has been very strong and it will continue to be so as the focus on climate change intensify.