The oil sector and commodities in general, are making a big comeback, ranking them among the top stock market performers year-to-date. This trend reversal comes after more than two years of steep declines, hinting that the commodities industry has surpassed its low point and that undervaluations are substantial. However, in accordance with our investment process, which calls for selecting undervalued stocks relative to their industrial value, we have only gradually been reintroducing some oil sector names for the past year.
After all, the mining sector is struggling with twin issues of supply and demand. Firstly, players in the mining sector have heavily invested in new capacities over the past 15 years in a bid to meet the infrastructure needs of emerging countries, and especially China. As a result, they are now at high surplus capacity levels that are weighing on commodity prices. Secondly, about 30% of global mining output comes from relatively unproductive, loss-generating Chinese companies. For this surplus capacity to be re-absorbed, these loss-making mines will have to be closed, and that will be dictated by the political and social agenda of the Chinese authorities, which is beyond our control. Meanwhile, listed companies have already completed the lion’s share of their cost reductions and now boast the lowest cash production costs in the world. Investment spending has been cut by 65% since 2012. These companies have thus exhausted their internal improvement potential.
Furthermore, the price drop has been accentuated by China’s economic slowdown, accounting for approximately 50% of global demand. Nor does the transition of the world’s No. 2 economic power from an industrial economy to a consumer economy mean there will be a significant upswing in demand in the short or medium term.
As a result, the only real hope for mining groups to improve their profitability is the rebound in commodity prices. Actually, the sector’s recent upturn can only be explained by the recent rise in commodity prices, which in our view makes the recovery fragile at this point because it relies too much on China’s political decisions.
Conversely, certain European oil majors offer a much more attractive investment profile. Their valuation and profitability are currently at record lows. As shown in the chart below, the sector’s devaluation is not directly related to the oil price decline. It can first of all be attributed to the decrease in profitability (ROCE), which took place way before oil prices began falling. Oil groups massively increased their investment spending in the early 2000s (+180% in 15 years), without succeeding in increasing production.
Paradoxically, the oil price decline is a positive catalyst because it is forcing oil groups to take the necessary measures to restore their ROCE levels.
Their ability to adapt their cost structure in a persistently low oil price environment has been underestimated by the markets, as we see it. For example, BP, currently held in our portfolios will have cut its investment spending by 30% and its operational spending by 25% in the space of 3 years. Plus, the use of existing oil wells is still a profitable business in the current environment, with a total cash production cost of $22 per barrel for BP in 2015. A similar observation can be made for Royal Dutch Shell, given its substantial undervaluation without even taking the synergies from the merger with BG into consideration.
We have gradually and selectively increased our exposure to the oil sector over the past year. Our choices are guided by the strict application of our investment process, based on enterprise valuations and our understanding of what the normative profitability should be for each industry, irrespective of its growth outlook.
This article has been excerpted from a recent letter of Metropole Gestion.