The oil price downturn is entering a regime that risks inflicting structural damage on balance sheets and asset bases of some companies. We still see value in part of the sector but only in a select number of companies – Shell, Total and Statoil.
Two possible outcomes for integrated oil: In commodity price downturns, oil companies tend to do four things: cut costs and capex, sell assets, borrow money and issue dividends in scrip. When downturns are not too protracted,
these measures do little structural harm. At their nadir, these cycles typically prove attractive opportunities. However, we now forecast oil prices to stay below $35 to mid-2017. This means the downturn is at risk of moving into a different regime, one that hollows out asset bases which become too weak to service debt and dividend burdens that ultimately become too high. In this case, 'value opportunities' are at risk of becoming 'value traps'.
But which one will it be? Whether the sector has crossed over into this second regime is uncertain. The tipping point will likely arrive sooner for some and later for others. In this note we address three questions to shine light on
the differences between companies: Who has FCF growth 'built in' into its portfolio? Which portfolios subsequently generate sufficient cash flow to fund a maintenance level of capex? And who can keep gearing in check?
Most resilient – Shell, Total and Statoil; all OW: These three score well on the above analysis and we believe they are likely to emerge from this downturn with still healthy asset portfolios, manageable gearing levels and
sustained dividend distributions in the intermediate period. In the fullness of time, their current dividend yields will likely turn out to be attractive.
We see weaker risk/rewards in OMV and Eni; both UW: We are more concerned about the rest of the sector. Taking into account current valuations, we believe that share price of OMV and Eni overstate the strengths of these
firms.
Sector view lowered to In-Line: The oil industry has been cyclical since its beginning, and is likely to remain so over the next decade. The timing of the upturn is notoriously difficult to estimate, but is likely to lead to material
upside in share prices. Hence, we argue that it is worth maintaining exposure to the sector, but only through those companies that have time on their side – Shell, Total, Statoil. The value of the rest of the sector is increasingly difficult to estimate if the downturn turns out to be as protracted as we currently fear. With this divide running through the sector, we lower our stance to In-Line.