The stock market has been hit by what legendary investor Warren Buffett recently described as a “one-two punch“. One punch was the coronavirus pandemic and subsequent lockdown that caused panic in the markets as investors worried about falling demand. Another was the oil price war unleashed by the dispute between Saudi Arabia (and other OPEC states) and Russia, with US shale producers and other Western energy companies getting caught in the crossfire.
Unsurprisingly, one of the sectors most severely hit in recent months is the energy sector. For instance, the Vanguard Energy ETF, which contains US giants like Exxon Mobil and Chevron, is down around 42% from February, compared to the S&P 500 (down 17.5% over the same period) and the FTSE 100 (down 25%). What does this mean for UK investors? Let’s dig in.
Survival of the fittest
Hammered by falling demand and excess supply, the price of a barrel of Brent crude oil (the global benchmark) is at $28 (£22). That’s approaching 20-year lows. This has created a lot of anxiety for US shale producers. They’d already been under some pressure even before the current crisis. For one thing, a lot of the easily accessible shale reserves in North America have already been tapped, so the per-unit costs of extracting more crude have been increasing. Last year, the number of bankruptcies in the shale industry increased by 50%. And there’s no doubt that there will be many more than that this year.
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Why does that matter to UK investors? I think that a shale shakeout might actually end up being good for oil majors like Royal Dutch Shell (LSE: RDSB) and BP, as the industry consolidates around stronger players in this space. Shares of Shell are currently trading with a 10% dividend yield. That’s not at good as the 17% yield it had when I wrote about the company a few weeks ago. But it’s still a historically good bargain. Of course, high yields should always be scrutinised very closely. They often signify that the market doubts the ability of the business to deliver on its promised dividend. But in Shell’s case, I think the reward justifies the risk. Shares of Shell are down 43% since early January, implying a large potential upside if the oil war is resolved.
In everyone’s interest for energy to recover
And there has been some progress on the negotiation front. US President Donald Trump has attempted to broker a deal between Saudi Arabia and Russia. He’s floated the idea of tying any aid for US oil producers to output cuts. Or perhaps the US government could buy up excess supply. These would be very unusual steps, of course. The US oil market isn’t state-controlled in the same way that the Saudi and Russian markets are, so the President can’t rule by decree.
But the fact these talks are even happening demonstrates that there’s a lot of political will to resolve the crisis. It’s in the interest of every party to establish a price floor for the price of oil. All of these factors combine to make Shell and other FTSE 100 energy companies attractive at current valuations, I feel.
