In this piece:

• Why recent performance and near-term forecasts aren’t driving share prices higher

• Why the hydrocarbon decline could now be quicker than expected

• Do valuation metrics support a tobacco-style investment in oil and gas producers?

I have to admit that I’ve always had a somewhat guilty fascination with oil and gas stocks. They’ve sometimes proved to be poor investments for me, and I don’t invest much in this sector these days. But I’ve found it hard to ignore the current combination of record profits and ultra-low valuations.

Take Shell (LON:SHEL),  for example. The FTSE 100’s largest company reported a record $40bn profit last week for 2022, more than twice the 2021 figure of $19bn.

No one seriously expects this level of profit to be repeated for the foreseeable future (at least, I don’t think so…), but forecasts for the current year still show a yield of 4.4%, covered nearly four times by earnings.

There’s plenty of headroom here, too. At the current rate of growth, Shell’s dividend might even return to its pre-2020 level in coming years.

More broadly, the big UK-listed fossil fuel producers all score highly for value and boast healthy StockRanks:

Is the market missing an opportunity, or is this a classic cyclical trap? I think the answer may lie somewhere between these two extremes, as I’ll explain.

Where are we now?

Let’s start with a look at oil and gas prices. This will give us a view of where prices stand today, compared to before the Ukraine-Russia war.

Brent crude is now trading back at roughly the same level it was before Russia invaded Ukraine.

Source: tradingeconomics.com

Gas prices have fallen back to pre-war levels too, after last summer’s buying frenzy. A relatively mild winter has meant that inventory levels have remained comfortable across Europe.

Although UK natural gas prices are still elevated by historic standards, the US natural gas benchmark has now returned to entirely normal levels:

Source: tradingeconomics.com

Market prices don’t seem to be suggesting any kind of imminent shortage. This may help to explain why the stocks I listed above have fallen by around 20% in aggregate since oil prices peaked in May 2022:

Note: to get this chart, I put the companies listed above in a Folio without any transaction data. Stockopedia will then generate a simulated performance chart and plot this against the folio’s benchmark – in this case, the FTSE All-Share index.

What’s next for oil & gas?

In the short term, market conditions may be influenced by the strength (or not) of western economies and a possible increase in demand from China’s reopening. Trying to predict the interplay of these factors is beyond my pay grade and – I’d suggest – probably futile.

All I will say is that Shell’s share price has previously been a reliable predictor of looming oil price slumps. The FTSE 100’s largest stock has previously peaked in 2001, 2008, 2014 and 2018/19. Make of this what you will…

Looking further ahead: I’m more interested in the longer view, in terms of potential investments. I think that one key element to consider is how future fossil fuel production will balance against the expected long-term decline in consumption.

As we saw in 2020 and again in 2022, when the market fears a significant mismatch between supply and demand, energy prices can become very volatile indeed.

One bullish argument is that since the 2014 oil price slump, the supermajors have cut back on capital investment. As a result, there’s a risk we could see a shortfall in future supply, as new production fails to replace declines in output from mature fields. This could lead to sustained higher prices and periodic spikes higher, as we saw last year.

This school of thought seemed to be gaining currency in 2021 – here and here, for example. However, I’ve seen less of it since the Russians invaded Ukraine. BP’s recently-published 2023 Energy Outlook provided one possible explanation.

Although BP (LON:BP.) believes that investment in oil and gas production will still be needed through to 2050, the company now believes that global carbon emissions could peak sooner than previously thought.

The US Inflation Reduction Act is given as one reason, but the main reason for this change in viewpoint is the war itself. According to BP, this situation has prompted many countries to focus on decarbonising their energy systems and reducing dependency on imported energy, which is dominated by fossil fuels.

Spencer Dale, BP chief economist, says that we’ve seen this pattern of behaviour before (my bold):

“... the experience from the major energy supply shocks of the 1970s suggests that events that heightened energy security concerns can have significant and persistent impacts on energy markets”.

BP now believes the war will lead to a lasting reduction in global GDP and accelerated changes to countries’ primary energy sources. This could mean that carbon emissions peak sooner than the company previously thought.

Source: BP 2023 Energy Outlook

This chart shows how BP’s 2035 energy source assumptions have changed since last year:

Source: BP 2023 Energy Outlook

There’s much more detail in the report for anyone who is interested. But I’d like to share two more charts that caught my eye.

BP expects OPEC producers to take a growing share of production over the coming decades.

Source: BP 2023 Energy Outlook

The firm’s modelling suggests that in almost every scenario, the biggest production declines will come from non-OPEC producers (dark green), such as UK firms:

Source: BP 2023 Energy Outlook

Where does all this leave us? As Megan explained recently, we can make a structural growth case for energy transition minerals such as copper, nickel, and zinc.

That doesn’t seem possible with oil and gas. Even some of the world’s largest producers are planning for a long-term decline.

The rate and extent of this decline is still very uncertain, in my view, but in the North Sea at least, clear plans are emerging for decommissioning over the coming decade (note this data only covers three major operators).

I think we could be entering a stage where fossil fuel producers become similar in some ways to tobacco firms.

People have been predicting the demise of tobacco companies for decades, but they remain large-scale businesses with attractive economies of scale and strong cash generation. They aren’t necessarily bad investments, at the right price.

Valuation: is the price right?

The UK oil producers included in my earlier graphic are all trading on super-low P/E ratios. However on other measures I think they look more fully priced:

Dividend yield: earnings in a cyclical business can fluctuate from year to year, but dividends tend to be sized so that they’re more sustainable. Most businesses don’t want to chop and change their payout policy every year.

For mature businesses like these, with limited growth prospects, I see dividend yields as a more likely indicator of their valuation. Broadly, I would say these dividend yields are fair value, not cheap.

In fairness, BP and Shell at least are far more efficient businesses than they were 10 years ago. Costs are under control and they are producing more oil and gas from reduced spending.

However, the forward picture is still a concern. The cost of debt and equity capital in this sector is widely-reported to have increased significantly in recent years. Other costs must surely be rising again, too. Future projects could cost more to finance, capping profitability. The energy transition remains a longer-term challenge.

In contrast, I think upstream-only firms Harbour, Serica, and Tullow are likely to have a more limited appetite to take on new debt. Borrowing costs will be higher than in the past. And with a growing number of producing fields in decline, I suspect borrowing money could become progressively more difficult.

Right now, I agree with Stockopedia’s algorithms. Valuations look cheap and momentum and quality scores are reasonable.

However, there’s no guarantee commodity prices will stay high – although they might.

Looking beyond that, no one knows exactly how the balance of supply and demand will change due to decarbonisation. Nor is it clear how much capacity or inclination OPEC will have to ramp up production.

Conclusions

As with tobacco stocks, I think oil and gas producers can no longer expect investors to price in future growth. Shareholders and lenders will want upfront returns – that means high yields and low valuations, in my view.

I think this sector will continue to offer opportunities to investors, but I don’t think it’s as safe as the current rosy consensus might suggest.