The volatility in the price of oil this year has thrown the complexities of investing in the oil sector into sharp relief. After almost three years of price declines and a supply glut, near-term prices have stabilized, a clear sign that the market believes the oversupply is coming to an end. Indeed, we believe demand next year will exceed 100 million barrels a day and that the capital expenditure of the producers needs to increase to meet the demand.
In a rising demand environment, it is the service providers and vendors that will do especially well, with much of this segment of the market currently undervalued. For example, oil rig operators are priced at very depressed valuations; over the last three years, oil rig operators' equity valuation is down almost 90%. New rigs can be acquired directly from the shipyards at a 30% to 40% discount to the cost price. By looking at these deep value opportunities, investors should benefit from the short-term uplift in the oil price without overexposing themselves to negative demand dynamics in the future.
A slippery slope
However, although the oil price is recovering in the short term, the historically cyclical sector faces fundamental secular risks. Most notably, oil businesses cannot ignore the corporate risk posed by environmental, social and governance concerns.
The biggest economies around the world are gearing up for significant policy shifts related to climate change that should limit demand to at least some degree. On an operational level, these policy shifts also are likely to target the processes used by oil companies.
With this in mind, oil sector investors need to look beyond the financial health of oil businesses when considering their mid- and long-term investments. The businesses that are best prepared for risks presented by a growing ESG awareness, alongside having strong balance sheets, reliable cash flows and diversified income streams, are those most likely to succeed.
One such business is Statoil, the $62 billion Norwegian multinational oil and gas company. The business is investing heavily in reducing the carbon intensity of its operations, even as it continues to produce oil. This is a trend we believe will spread through the industry.
From risk to reward
The upside of focusing on oil businesses that are mindful of their ESG impact is that reducing carbon impact can reduce a business' exposure to the fluctuations in the oil price. Dong Energy, a Danish integrated energy company, was considered a risky investment in the past, due to its exposure to oil and its fluctuating price.
In the past four to five years, Dong has transformed its operations and, this year, became the first energy company to fully shift its portfolio from carbon. It is spending its capital expenditure on renewable energy while selling its carbon-intensive energy revenue sources such as coal and oil. At the same time, it has flourished financially, with its share price rising almost 30% over the five-year period through the end of August 2017.
More broadly, ESG factors have had a proven impact on stock price performance in the oil sector. Our proprietary analysis shows the worst performing oil businesses in ESG terms have underperformed the sector by an average of 30 basis points a month.
Shorter durations for the longer term
Although focusing on ESG-conscious oil businesses is beneficial for now, the secular decline in demand that is likely to stem from the wave of changes in policy and in public perception means investors need to look more broadly at their oil allocation. The cultural shift away from carbon-intensive energy production is already underway, with approximately 40% of Denmark's energy supply now coming from renewable sources.
In this context, the decline in demand over the next two decades could be substantial. With the lead time on some projects extending across several decades, it is prudent for investors to look at the duration of businesses' projects alongside their sustainability. By investing in businesses with a shorter duration portfolio of projects, investors can benefit from the drivers now supporting the oil industry, without exposing themselves to businesses leveraged for an uncertain future.
Geir Lode is the London-based head of global equities at Hermes Investment Management.This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.