Oil shares have never been this cheap – but will they just get even cheaper?

Oil workers © Greg Smith/Corbis via Getty Images

Oil production is falling

(Image credit: © Greg Smith/Corbis via Getty Images)

published 16 October 2020

It’s only been about a week since I last wrote about oil. But I’m finding it fascinating at the moment. Like most value-orientated investors, I just can’t resist constantly returning to a sector that relentlessly gets cheaper and cheaper.

Of course, as many value investors have learned to their cost in the last decade or so, things that are cheap can just carry on that way until they’ve gone all the way to zero (or below, in some cases).

But when you’re talking about a group of companies selling what is still one of the most important commodities in the world – I just can’t help myself.

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The oil sector is staggeringly cheap

Louis-Vincent Gave at research group Gavekal has just put out a piece on oil prices. As ever with Gave, it’s extremely interesting. His core point – one we’ll return to in the future – is that oil, the US dollar, and US government debt have all been trading in a tight range since March. Those are all really important prices. If they start to trend properly in one direction or another, then we’ll have a very different investment environment on our hands.

But in this piece he focuses on oil. He looks at both the bearish and the bullish case, but I really just wanted to highlight some of the incredible statistics that are in his piece. He points out that energy stocks are now the smallest sector in the MSCI World index, with a weighting of just 2.48%. That compares to Apple, with a weighting of 4.46%. In other words, Apple by itself is almost twice as significant as the entire listed energy complex.

OK, Apple is the virtual, shiny, ultra-hygienic future into which we are being propelled, while oil is the real-world, gritty, dirty present day that we are apparently leaving behind. But we don’t all run on batteries yet, and even in lockdown some of us need to get from A to B and sometimes even to C. And the latter requires cars and occasionally planes.

So does that disparity in valuation make sense on the fundamentals? Or is it being driven more by an environment that puts little value on the present relative to the future, because of ultra-low interest rates? Is it all part of the “long duration” bubble? I’m guessing it’s the latter.

Meanwhile, for the first time ever, says Gave, “the broad energy industry is trading at below book value.” In other words, companies are trading for less than the value of the assets on their balance sheets.

That’s fascinating and it’s genuinely unprecedented. It’s also only happened this year. For roughly the decade after the financial crisis, the MSCI World energy index traded at around 1.5 to two times book value. Prior to that it was a lot higher – from 1996 to the financial crisis the low was about two and the high above 3.5.

And the fact that oil has proved to be such a poor investment in recent years means that “energy may well be the only major industry in the world today that is genuinely starved of capital.” Investors aren’t willing to pour yet more good money after bad simply to allow oil companies to keep spending too much to get a depreciating asset out of the ground.

As a result, oil production is falling. That doesn’t matter just now because demand has dropped hard. And with countries around the world locking down to varying and confusing degrees all over again, it’s not likely to bounce back sharpish. Yet what happens when it does?

Moreover, as Cris Sholto Heaton points out in the current issue of MoneyWeek, out today, the oil price doesn’t have to be high for oil producers to make money. If the majors are no longer squandering money in the hunt for new oil, and are instead just hunkering down and running down their existing resources – well that could be very profitable indeed. The oil stocks could be like the tobacco stocks were – unpopular, dirty, but absolute cash machines.

There’s probably no rush to dive in to the sector. But it’s something to stay aware of.

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A great deal has changed in the last 20 years – and I’ll admit that capping the past two decades with a global pandemic was not high on the list of things we expected to happen – but we want to focus on what might happen in the next 20.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.