Is The Low Oil Price Too Slick For Equity Investors? by Joseph G. Paul, Jeremy Taylor & Akhil Kapoor, AllianceBernstein
Many investors are still stumped by the low oil price. Yet there are effective ways to position an equity portfolio for an eventual rebound—without getting hurt in the meantime.
It’s early January and the oil price is already making news again. Concerns that Iranian crude may soon come back onto world markets and renewed worries about Chinese demand drove the oil price lower this week. On Tuesday, January 12, Brent crude was trading at $31.7 a barrel, down by about 6% from its opening price on Monday morning.
About a year since oil first fell below $50 a barrel, there’s still no tangible sign of an imminent recovery. Energy companies have cut spending on drilling, rigs have been shut down and demand has been robust. Yet the oil price remains stubbornly low, as OPEC continues to refuse to cut production while flooding the market with surplus crude.
When the slump started, we argued that the oil price can’t stay this low forever. And we still think the underlying economics of production should drive the oil price back above $80 per barrel within five years. But the near-term outlook is uncertain. Iran, Saudi Arabia and other producers may pump even more supply into the market, so low prices could persist through much of this year.
Many active managers today are underweight energy stocks. That’s fine if the low oil price is here to stay. But if a recovery develops, portfolios that are steering clear of the energy sector will miss out. Instead, we think equity investors should take three steps to position for a low oil price in the near term and for an eventual recovery.
1. Think creatively about oil exposure
Start by taking a thoughtful approach to energy. In our view, this means being efficient with your energy positions by investing in stocks that are more sensitive to the oil price (Display) but can provide exposure to a rebound with a relatively small weight. Companies with strong balance sheets can provide protection while oil prices remain low. Examples include exploration and production companies, like EOG Resources and Hess, which should enjoy a sharp rebound if the oil price recovers.
Within the energy sector, different types of companies are affected in different ways by oil price shocks. Refiners may hold up well today because low prices trigger demand for services and products, which fuels higher margins. Services companies are often late to recover from a supply-led shock. So today, it’s important to balance the sources of exposure within the energy sector. Consider holding some refining companies that can do relatively well in the current environment, along with producers that are highly sensitive to the oil price and could lead the way in a recovery.
2. Don’t ignore the majors
It’s easy to understand why the largest oil companies seem off-limits to many investors today. Can these companies adapt to the low oil price? How can they keep costs down while investing for the future? Are they really going to keep up their dividends?
Good questions. But the answers aren’t black and white. In today’s environment, we favor companies that are cutting costs, as well as reducing capital expenditures, to help support cash flows through a tough period. In recent months, several companies—including Total, BP and Shell—have set out ambitious plans to cut costs.
These European integrated-energy groups pay high dividends (Display). By slashing operating costs and by deferring all but their most attractive future projects, they are releasing cash flow for shareholders. As the heavy investments of recent years come on stream, they can afford to slow investments now. For example, Total believes it can reduce its capex by about 30% over time, from $26 billion in 2014 and still sustain modest long-term growth. Companies with low debt, significant cash reserves and assets to sell provide added appeal while oil prices remain low. In our view, those that invest wisely for the future while cutting enough costs should be able to keep paying dividends—and many trade at attractive valuations.
3. Look beyond the energy sector
With oil prices at such extreme lows, look out for stocks that could benefit from a long-term recovery in the oil price in ways that aren’t obvious. For example, US petrochemical producers, such as LyondellBasell, Dow Chemical and Westlake Chemical, use cheap US natural gas as feedstock. Their global competitors rely mostly on oil. So when oil prices rise, product prices should increase across their industry, and these producers could benefit disproportionately—because their costs are driven by cheaper natural gas.
Similarly, in utilities, rising oil prices can make an impact on power prices in certain markets, affecting power producers in different ways. On the flip side, airlines are benefiting today from low fuel costs. So airlines can provide good hedge during high oil price volatility.
Oil price sensitivity is embedded in equity portfolios in many ways. Today, in an especially tricky environment, we think it’s too simplistic to avoid the sector completely and quite risky to try to time a recovery. Instead, think actively about preparing a portfolio for an uncertain future, without overlooking the potential for a big rebound to develop over time.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.