January 2018 | Eugene Khmelnik, Global Industry Analyst
We believe our GIAs — specialist stock pickers for whom industry research is a career path — are one of Wellington’s key differentiators. Their role is to use fundamental analysis to identify investment opportunities for clients’ portfolios. It is our belief that stock selection based on in-depth knowledge of an industry has the potential to generate strong investment performance over the long term.
Directly after completing a bachelor’s degree in finance, I joined Wellington in 2008 as part of the Launch Research Associate program. This two-year rotational program is designed to give graduates a series of placements with different teams around the firm. My first placement was with Karl Bandtel, who then led the oil team. The team needed help and I loved the sector. It was an exciting time, with the start of the shale revolution in North America. I was fortunate enough to be asked to stay on the team and have been able to grow relationships with shale management teams as their companies have evolved.
The firm has a great culture of sharing knowledge. As a younger member of the team, I have constantly benefited from older members passing on their accumulated wisdom. That applies not only to my sector, but equally to the broader financial markets.
My team’s dialogue with our credit analysts has been especially productive. In 2016, oil fell as low as US$29, causing widespread bankruptcies in the sector. It was an excellent example of collaboration, where we, on the equity side, had in-depth knowledge of oil companies’ assets and the credit analysts understood the covenants — the legal agreements between the bond issuers and buyers — and the specific debt metrics. They helped us to better appreciate which companies were likely to break their covenants, while we helped them understand which companies could still make a profit with oil prices so low.
It’s hard to predict commodity prices with any precision (Figure 1). And the further out you go, the more difficult it becomes. But, when the market is at an extreme, it is easier to take a position on a commodity price.
To figure out when that is, we look at a range of factors. These include whether capital is leaving the industry, the number of initial public offerings, and the rig count. We also look at high-yield energy spreads. When they rose above 10% in 2008 – 2009 and again in 2016, they signified an extreme. We also look at sentiment — how investors are positioned in energy relative to history and to other sectors.
Currently, the oil price appears rangebound. When prices approach the upper end of the range, short-term projects (such as shale) come on stream to take advantage, putting downward pressure on the price. When prices approach the lower bound, those projects become uneconomical. Oil has probably the highest natural decline rate of any commodity. So the price often doesn’t stay low for long.
If rising inflation leads to higher interest rates, that could rein in shale production more than the market is expecting. Shale has vast supply at a low cost, and it’s driving the US to become much more energy-independent. But the industry is only 10 years old and has never had to cope with high interest rates. The amount of capital expenditure (capex) on shale — and on energy in general — may prove to be unsustainable.
Unlike much of the rest of the economy, which is service-oriented, energy requires a lot of capital because of its natural decline rates: Oil and gas wells are constantly being depleted. In recent years, energy companies have seen significant flows from the high-yield market and private and public equity. That is starting to change. Markets are requiring these companies to focus more on returns and less on growth, so that they can return some of their cash flow to investors via dividends or buybacks.
It’s good to see greater capital discipline in the sector. However, when interest rates return to more normal levels, the cost of capital for these companies will rise even further. Capital flows from the private equity and high-yield markets may dry up, which could finally take the oil price out of its trading range.
An alternative driver might be the reintroduction of a geopolitical risk premium. There are several sources of uncertainty currently, including the new ruler in Saudi Arabia, the Trump administration’s stance on Iran, and the instability in Venezuela.
It’s important to remember that not every stock is a play on the oil price. For example, the shale revolution has turned the US from a major importer of oil and petroleum products to an exporter. One niche area we’re looking at is tankers for liquefied petroleum gas (LPG), a cheap and abundant by-product of oil and gas drilling. As domestic demand can’t keep up with the supply, it is exported in specialized tankers to places such as China, India, and Latin America. We think exports of LPG products will continue to increase, which should benefit some of these tanker companies.
Over the past 12 months, many US oil stocks have significantly underperformed the oil price. These include not only exploration and production companies, but also midstream master limited partnerships (transportation, storage, and royalties businesses). They could do well if the oil price stays at current levels; it doesn’t need to rise further from here.
In Europe, a lot of the oil majors have kept pace with the oil price because shareholders like their focus on capital returns, so we see fewer valuation opportunities there.
The right geological conditions for shale exist in parts of Europe and China, but they are in areas of higher population density than the shale basins of North America. In addition, governments in these countries tend to own the mineral rights. In the US, landowners do, which means they get a royalty. One of the few places outside North America that we are watching closely is Argentina. Several large overseas companies are coming in and doing joint ventures with local businesses.
We generally find that the market focuses too much on the upside and not enough on downside protection. That’s because most people who invest specifically in energy are looking for a levered play on oil and gas prices, and they will have a target price in mind.
Yet downside and upside risks are asymmetrical: A 20% gain doesn’t make up for a 20% loss. So we prefer to look at ranges for every stock we own. We want to make sure we understand the downside and upside potential as well as possible and then aim to select stocks where the range of projected returns is in our favor, not just stocks with high potential upside.
With an international transition to a lower-carbon economy underway, many teams at Wellington are focused on our responsibility to help our clients understand the potential effects of climate change on...Read more
Looking beyond the first-round effects of the recently passed US tax act, our head of US macroanalysis considers the longer-term impact on capital raising and capital allocation decisions, economic growth,...Read more
In this collection of our most recent thought leadership, our experts grapple with the role of active and passive strategies, unpack new developments that suggest the potential for further EM...Read more
Our China equities portfolio manager believes that asset owners need to better understand the A-share market and what their inclusion in global equity indexes may mean for their emerging markets...Read more
Eugene Khmelnik, who specializes in the oil sector, examines what rising interest rates may mean for the shale industry, which has so far only existed under extremely loose monetary policy....Read more
This content is intended for institutional or professional investors only and is restricted to our Insights subscribers. You may already be a subscriber if you receive our regular Insights emails or if you are a client.
Please verify your subscription by providing your email address below.
Thank you for your interest in our Insights content.
Your information is not on our subscription list — please register to access this content.
I certify that I am a qualified institutional or professional investor and would like to become an Insights subscriber.
Please verify your subscription by providing your email address below.
Thank you for your interest in becoming an Insights subscriber.
Sharing our investment knowledge is an important part of our client-centered culture.
Since our content is intended for institutional or professional investors, we will email you regarding your subscription after a brief internal review process to verify your status.