Navigating the investor landscape for North America unconventionals
Amid concerns of credibility, cash flows and carbon, investors are shying away from the oil and gas industry. What's behind investor apathy? And, how are E&P strategies changing? Kevin Roy, a lead analyst from our financial services advisory team, and Dan Pratt, from our Companies & Transaction analysis team join Upstream in Perspective to discuss. Here's an excerpt of the conversation:
Kevin, last week the equity research shop, Redburn, published a report to clients where it downgraded all the energy majors citing valuation concerns on the idea that oil demand was not going to be as high as once expected.
We've seen a lot of other media reports and investor concerns and bankruptcies. More specific to North America operators' ability to generate financial returns and cash from unconventional oil and gas development. Are you noticing this news play out in actual investor commitments to these companies shares?
Yeah. Absolutely. What I would say is not only are we witnessing that, but it's really accelerated over the last 18 months or so what had already been probably a 10-year trend of institutional investors—investors that represent the largest ownership of publicly-traded energy companies, who are reducing what we call exposure to the energy sector. So, whether that's upstream, midstream, or downstream, and specifically North American E&P companies. For that group, the exit or the reduction of exposure has really accelerated over the last couple of quarters.
So, the trend your saying is about 10 years old? But the acceleration is more recent and isn't necessarily tied directly to that 2015 price collapse?
Yeah. That's the way we think about it when we talk to our clients. Ten years ago, the energy sector represented 10%, a little over 10%, of the S&P 500 Index. Fast forward to today, and the sector represents less than 5% of the S&P 500 Index. So that's a pretty dramatic reduction of the energy sector's presence. Certainly, a catalyst would have been the 2015 collapse, but it's more about investor decisions to allocate capital to a sector that has not done a very good job of returning capital to shareholders or just really demonstrating a return on their invested capital. Meaning, the dollars that they invest in drilling for a well and earning a return on that capital that they deployed for that well.
Well, you mentioned the index. I think last month was the first time in almost 100 years that Exxon fell out of the top 10 of the S&P 500 Index. So, this is hitting all the small North American E&P's, but it's moving all the way up to the large integrateds too.
Yeah. That is shocking. Particularly for a company the size of Exxon. I would add that there's another dynamic at play here in the broader equity markets for those of us who invest in 401k's. We give our money to -- we'll call it a Fidelity or Vanguard. Fidelity is what we call an active investor. So, when I was talking earlier about investors really exiting the space, what I was talking about were these active institutional investors who have portfolio managers and analysts who make decisions on what company shares they bought. That group of investors in the market are really the ones who are reducing exposure to energy companies and E&P companies.
What has also been happening in the broader markets is, those active investors are losing their own investors or clients, you know me and everyone else, because we're rotating our money to the Vanguards of the world. Vanguard is what we call a passive investor. Meaning, they look at an index like the S&P 500, and they allocate the money that they have to invest based on the weighting that we're talking about. So, while that's happening, the passive owners of energy companies is actually increasing.
So if the passive is 5% to match the index, then the active is 1-4%.
Huh. So, Dan, from where you sitting and analyzing…your team has been analyzing these companies for some 20 plus years. Obviously, Exxon falling out of the top 10 S&P 500 is new. How has this resembled or how does this feel different than the priors? This is a cyclical industry, so energy falls out of favor almost predictably every several years or decades.
Yeah. Just to go back to Kevin's point. The trend, the sector rotation out of energy is an even longer term than that. Go back to the 90's, energy was about 15% of the S&P, and a decade before that it was 20-25%. So, this has been a long-term trend and increased tremendous pressure in terms of competition for capital. Not only is it, how do companies compete for capital with these other sectors? But if their pie or their share of that capital is shrinking, how do they compete with their peers for that capital? And how do they differentiate themselves? How do they get their story out to investors?
So it's certainly been trickling down and put a lot of pressure in terms of their business models going forward. If you bring in more of what we've seen here recently…if you look at the share performance, you know the integrateds have actually done a little bit better. They're down about 10% over the last 12 months, but the E&Ps are down 40-60%.
Sorry. Is the integrateds up performance would you say that's more tied to yields? Some of these companies are generating 4 or 5% dividend yield. Or, is it just the value of refining and marketing within their integrated operations? Or, a combination of both?
I think it's a combination of both. The integrateds business model allows you to sustain your profitability a little bit better through the peaks and valleys. But, I do think these guys have a business model set up for what investors are looking for today in terms of return of capital, higher dividends, etc. So the business model in the downturn supports them.
But in terms of why it feels little bit different this time, Hill, I think in the past boom and bust cycles, it's been more about, "Are we going to have enough oil? Or, is there too much oil compared to the future demand for fossil fuels?" This time it's very much a question of, "Is that demand going to be there?" So short-term, we have these supply concerns, but longer term if you look at what's happening in terms of fears around peak oil demand, de-carbonization and the whole energy transition. There feels to be some real concern about what level of demand we're going to see in the future for fossil fuels. So, that's what to me feels a little bit different this time.
Posted 20 September 2019
This excerpt has been professionally transcribed as accurately as possible. Please note, some words and phrases may have been unintentionally excluded.
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