Anyone who has been a portfolio manager for the Energy sector knows full well how "boring" and "underperforming" returns have been just holding the Oil Majors like BP (BP) , Royal Dutch Shell (BP) Total (TOT) or Exxon Mobil (XOM) . Over the past four years, they are still trading at more or less the same dollar level vs. the S&P 500 -- up about 30% since 2015. Most funds pitch investments in the Majors as an attractive dividend yield orienting story.
Being a graduate from the school of hedge fund management myself, we know very well that this argument holds no water, as all we care about is absolute performance: An investment does not make the cut if it is not forecasted to return at least 20%. Hence, they are mostly a source of funds in a portfolio; sold against buying some of the other, racier names in the sector. Majors should not be written off entirely, though. There are times to own these names, one just needs to get the timing right, as during that time, they can significantly outperform the market and other sectors.
That time is now. Oil majors, specifically Royal Dutch Shell, Total, and Equinor (EQNR) , have never looked cheaper or more attractive than they do now. Why? Brent Oil is trading around $63/bbl. It has been trading between $60-$63/bbl this year. There is a case to be made for why oil can be supported here, with risk to the upside if U.S./China trade talks reach some sort of conclusion or a deal. We are in the heart of the key winter season and so product demand is strong, as inventories draw down into the Spring. In addition, OPEC and OPEC+ have been cutting production as per their agreement in December to take around 1.2 million barrels per day of oil out of the market.
There was excess oil in the system, but that is clearing up now, at a time when seasonal demand picks up. This is offset by U.S. shale ramping up -- as seen by the latest EIA (Energy Information Administration) forecast calling for 12.41 million barrels per day (mbpd) vs. 10.9 mbpd in 2018.
This forecast needs to be taken with a pinch of salt, as we know how "accurate" these agencies are, more backward looking and extrapolating than actually forecasting. They can be forgiven, as demand is the unknown factor -- especially as Trade Wars loom over the markets, making it hard to predict what actual demand is vs. expected demand. Suffice it to say, for the time being, oil markets are more balanced for the next few months.
Most of the oil majors finished reporting very strong fourth-quarter 2018 results over the last few weeks. Shell's adjusted earnings for the quarter came in at $5.7 billion, up 32% year-on-year, beating consensus of $5.4 billion. Its cash flow generating capacity from operations was impressive, with free cash flow at $16.7 billion during the fourth quarter, and $39.4 billion during 2018, up from $8.0 billion and $27.6 billion in the third quarter and 2017, respectively. With gearing around 20%, they announced a new tranche of buybacks at $25 billion up to 2020. With a dividend yield of 6.1%, it looks cheap here on about 11x P/E for 2019.
Total's adjusted Q4 2018 net income came in at $3.2 billion, up 16% from a year earlier. Hydrocarbon production was extremely impressive at 2876 mbpd, up 10% vs. last year, due to ramp-up of new projects, with production expected to grow by 9% in 2019 - impressive indeed. For an oil major that generally suffers from diseconomies of scale, to move the needle on growth is a feat in itself. And 9% growth is almost on par with some high-risk Exploration & Production companies.
Gearing fell to 15% in the quarter. With a strong cash flow position, the company announced a further $1.5 billion share buyback. It trades on 10x P/E of 2018 with a dividend yield of 5.5%.
Given the wild oil price swings witnessed from 2014 through today, oil majors are more cautious on overspending. They retain a prudent stance and are focused on returning cash back to shareholders rather than destroying capital -- a noble venture.
With oil prices supported here, and with upside risk of moving higher if trade talks end well as the inventory overhang is now removed, Royal Dutch Shell and Total are the top picks here given their solid balance sheets, high free-cash-flow generation, top-quartile production growth and attractive valuations.