Volatility in oil and gas – who could benefit?

Oil prices have been lofty of late. While we’ve seen the cost of a barrel come down from highs near $120, the price of oil is still elevated compared to historical levels. This has all been caused by a supply and demand imbalance – one that’s showing very few signs of changing.

There are some potential forces that could lower prices – namely a looming recession and the ongoing energy transition. However, some believe oil prices will continue their run in the near term.

Opportunity in the oil and gas sector?

Over the past year, investors have piled into the oil and gas sector. The more expensive oil becomes, the more profitable companies in the sector tend to become. But the sector’s fortunes tend to wax and wane with the economy, so we could be at the top of the cycle.

Supply shortages could persist, despite the impaired demand that comes alongside a recession. OPEC+, a coalition of oil-exporting countries, has agreed to take roughly 2% of the global supply out of circulation to protect against the weakening global backdrop. The cut comes despite already tight supplies.

This suggests the group’s aiming to keep prices near their current levels. For that reason, many think the window of opportunity for oil and gas stocks is still cracked open.

With that in mind, here’s a look at two of the UK’s biggest oil and gas companies and how they could fare in a volatile environment.

This article isn’t personal advice, if you’re not sure if an investment’s right for you, seek advice. All investments fall as well as rise in value, so you could get back less than you invest.

Investing in individual companies isn’t right for everyone. That’s because it’s higher risk, your investment depends on the fate of that company. If that company fails, you risk losing your whole investment. If you cannot afford to lose your investment, investing in a single company might not be right for you. You should make sure you understand the companies you’re investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.

Shell – strong spot to catapult forward?

One of the biggest issues facing Shell over the past few years has been debt. The group was already struggling with ballooning debt levels when oil prices crashed in 2020 – net debt climbed to about 2.5 times cash profits (EBITDA).

However, this trend changed quickly last year on pumped-up oil prices. Cash profits rose substantially, and some of that money went towards chipping away at the group’s debt pile – in 2021, total debt had fallen around 17%. This fed into a significant reduction in leverage, making Shell look much more financially sound moving forward.

Leverage at Shell

Source: Refinitiv, 20/10/22.

So where does Shell stand as we head into a period of increased volatility?

That depends. The group’s been slow to wean itself off its reliance on fossil fuels. In the near term, this has its benefits. The returns from renewables are still largely unproven and oil’s still very much in the picture and will be for decades.

Shell breaks even when oil prices are above $60.51 per barrel, but could remain in operation if prices were to drop as low as $20 per barrel. Given that prices are expected to remain elevated through 2023, that puts the group in a strong position to continue shoring up its balance sheet and investing in growth.

Shell’s hedging its bets, with plans to change with the times, but no specific pledge to trim production. Instead, the group’s said it expects oil production to decline by 1-2% each year this decade.

While clean energy is the goal, the group’s putting the onus on the industries it serves to start demanding cleaner products before it dives head-first into a full strategy shift. The group’s pledged to invest about a third of its capital expenditure budget on low and zero-carbon products and services. That’s expected to rise to around half in 2025.

It’s also pledged to achieve net zero in its own operations by 2050. That’s not to say, however, that its products will be carbon neutral.

Compared to peers, Shell’s a laggard when it comes to operating in a lower-carbon future. While the group’s commitments to net zero could be considered ‘sufficient’, it’s also starting from a lower base.

On top of the exposure that comes from simply being involved in the industry, Shell’s got its own specific issues.

Involvement in oil sands activities, a particularly harmful method of drilling, as well as its Nigerian operations, which have been behind a number of damaging spills, are dragging down the group’s ESG credentials.

This is something to be mindful of as climate-centred regulations continue to evolve, turning ethical concerns into financial ones. We’ve already seen the start of this with Shell’s battle against a Dutch lawsuit resulting in a court ruling dictating a targeted reduction in emissions targets.

The push toward energy independence in the wake of the Ukraine/Russia conflict means the group’s in a strong position to play catch up. So far, Shell’s taken more of a ‘wait-and-see’ approach to renewables than some of its peers. That means it has more flexibility, and income, from its legacy assets to build out its presence in the clean-energy space.

With the group’s current head of Integrated Gas and Renewables, Wael Sawan set to step into the CEO role in just a few months, we could see Shell ratchet up its transition.

Shell’s uncertain future is reflected in a valuation that’s significantly below the long-term average. On top of being underwhelmingly prepared for the shift toward cleaner energy, Shell’s also largely dependent on oil prices – something that’s outside the group’s control. That means there could be something of an opportunity here if the group can improve its long-term growth proposition.

But given the volatility we’ve seen over the past few years, we think caution is warranted.

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BP

Like Shell, BP’s profits are tied to movements in oil prices. But the group offers a somewhat different investment proposition.

There’s no question that BP’s bread and butter is still the black stuff. However, the group’s positioning itself as a leader in the sustainable revolution, rather than hanging back to wait for a societal shift first.

Capital expenditure (spending) ($bn)

Source: BP 2021 Annual Report.

BP’s spending on gas and low-carbon energy was just about equal to its investments in oil production and operations last year. The group doesn’t break out exactly how much went to natural gas, which is still a fossil fuel, albeit a cleaner option than oil or coal.

By 2025 the group’s pledged to funnel over 40% of its capital expenditure budget into energy transition businesses like bioenergy, electric vehicle charging and renewables.

Meanwhile the group’s made a direct commitment to cutting oil production – with 40% expected to be shaved off by 2030. In 2021, less investment in this part of the business meant underlying production fell 3.8%.

There are clear advantages to this strategy.

First the group’s established itself as one of the most sustainable picks in the oil and gas industry. Responsible investing has been gaining momentum. Those looking to benefit from the oil price surge, while keeping sustainability in mind, would find BP near the top of the list.

Plus, if regulations do evolve to make it financially painful to be a polluting company, cleaning up your operations is a multi-year process that BP will have a head start on.

But there are drawbacks too, particularly if oil prices stay high.

BP breaks even at around $40 per barrel, but requires prices around $60 per barrel to maintain its dividend policy. That’s contributed to superb cash generation recently at BP – the group’s expecting free cash flow to more than double for the fourth time in six years this year. That’s thanks to the group’s oil assets, not renewables.

That’s why although climate advocates will praise the group’s decision to cut oil and gas production intentionally, that could create some financial uncertainty.

So far, the returns on renewables are largely unproven, though the group estimated it could make returns of 8-10% on its renewable investments. BP lumps renewables in with gas, but given their newness, they’re unlikely to be in the black yet. As BP reduces its oil output, this could eventually eat into cash generation and ultimately disrupt shareholder returns.

Although BP is an industry leader when it comes to sustainability, it’s still doing a fair amount of damage to the environment. While the group’s making strides to reduce its impact, absolute emissions from the products it sells are expected to continue growing through 2030. That means it could also feel the sting of regulatory interventions as climate change concerns continue to gather pace.

BP’s valuation is some way below the long-term average, thanks to uncertainty ahead. If BP’s able to shift its focus to renewables effectively, without sacrificing cashflow, the group will be a top-performer in a more sustainable future.

However, that’s far from a certainty, and BP will need higher oil prices to persist in order to fund this massive transformation. For now, it looks like this will be the case in the short term, but the longer-term outlook is murky.

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Unless otherwise stated, estimates are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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