April 20, 2018 / 6:21 AM / 6 months ago

Oil stocks face crucial earnings test as investors venture back in

LONDON (Reuters) - Formerly skeptical investors are buying back into oil majors in the hope that upcoming results will mark a turning point for energy stocks which have failed to keep pace with a surge in crude prices.

FILE PHOTO: Oil pumping facilities are seen at Venezuela's western Maracaibo lake in Venezuela, November 5, 2007. REUTERS/Isaac Urrutia/File Photo

Oil stocks could begin to close that gap if results live up to lofty expectations, with Goldman Sachs predicting the strongest free cash flow figures in a decade for the sector.

Oil is the best-performing global asset this year, with Brent crude up 11.4 percent since January, but energy stocks have continued to lag the commodity. While Europe’s oil and gas sector .SXEP is the best-performing year-to-date, it still has a way to go to catch up with crude.

The gap between returns from Brent crude LCOc1 and from MSCI’s global energy index .MIWD0EN00PUS from the start of 2017 has widened to 25 percentage points.

For graphic on oil stocks lag crude click tmsnrt.rs/2DPMJUs

For investors who put money on a revival in oil stocks a long time ago, the wait has been taxing, and baffling.

“We had an overweight all through last year, it was horrendous,” said John Surplice, European equities fund manager at Invesco Perpetual.

“They underperformed the market even though fundamentals have improved quite dramatically. I struggle to answer the question why they’ve been so poor until the last few weeks,” he added.

The correlation between WTI crude and share prices has fallen from 90 percent in 2017 to just 36 percent so far this year, according to PVM analyst Tamas Varga, perhaps signaling investors’ lingering doubts about oil companies’ ability to translate higher crude into better shareholder returns.

For graphic on European oil stocks EPS rises click reut.rs/2HaYq8V

Surplice still has a big overweight in oil and gas, a sector he considers defensive despite many investors remaining skeptical. “Cash flows are growing rapidly, dividends are very good and you’re starting to get some buybacks,” he said.

The fact higher oil prices have not yet trickled down into shares leaves a lot of room for gains.

With oil prices currently at $74 a barrel, Europe’s exploration and production firms are pricing in a long-term oil price of just $52 per barrel, Barclays analysts estimate.

Senior management at big oil companies is also aware they still have to put their money where their mouth is for the shares to begin recoupling with the commodity.

For graphic on April 19 Energy stocks valuations click reut.rs/2JXztzD

“We’ll need to show for a little bit longer that we actually mean what we say in terms of capital discipline and returning excess free cash flow to shareholders,” said Shell CEO Ben van Beurden in a briefing on Monday.

“The newfound religion and confidence in the sector is, to say the least, fragile,” he added.

There are at least some new converts.

Eric Moore, an income fund manager at Miton Group who used to be wary of oil stocks due to dividend yields he saw as dangerously high, has now moved to an overweight on the sector.

“With the rise in oil prices that we’ve seen, the sustainability of the dividends is better,” he said.

The damage of the 2014 commodities downturn, along with the rise of mega-cap technology stocks, has taken energy stocks’ share of the total MSCI World market cap to its lowest in 17 years, meaning global investors have ample alternatives available if they want to avoid the sector completely.

It is these generalists that oil companies will have to convince in results.

For graphic on April 19 energy share of global market cap click reut.rs/2JZQNnt

RESULTS REDEMPTION

Brokers JPMorgan, RBC, Goldman Sachs, Morgan Stanley and HSBC all believe the oil sector’s first-quarter earnings will deliver strong cash flows and higher dividends.

“We see the upcoming results season as a chance at redemption for the group,” wrote Biraj Borkhataria, oil analyst at RBC.

Goldman Sachs analysts see the European big oil companies delivering the highest free cash flow in almost a decade. Earnings estimates have recovered to their highest since 2015.

And these bigger cash piles should translate into dividend increases. Oil majors have long avoided cutting their dividends, making a dividend hike an even more powerful signal. “A dividend hike is forever,” Morgan Stanley analysts wrote.

The fundamentals of the oil market are also convincing investors that the crude price surge is more than just a blip.

Backwardation - whereby longer-dated crude futures are at a lower price than the nearest month - is good for oil companies, and several analysts pointed to signs of rising supply constraints in the crucial Permian basin oil-producing region in the Southern United States.

For graphic on April 19 oil price scatter graph click reut.rs/2J97BHw

“LIKE TURNING AROUND A SUPER TANKER”

Brokers’ high expectations have, however, made some investors wary of betting the farm on oil majors.

“We are neutral on European energy, driven by the fact they have had a lot of positive earnings revisions. It’s becoming more of a binary outcome,” said Pierre Bose, head of European strategy at Credit Suisse Wealth Management.

Positioning on the sector is still at average levels, Bose added, an indication many investors are still on the fence.

A main challenge for investors is how to time their rotation back into the sector, and tailor it to the turning tide in the oil market.

For graphic on crude price versus oil stocks April 19 click reut.rs/2JWPrtS

“You do get these things happening with cyclical stocks - the sentiment just gets overdone and it’s like turning around a super tanker,” said Richard Robinson, oil fund manager at Ashburton.

Far from a pessimistic sign, he reads the divergence between crude and stocks as a buy signal.

“The last time we saw that big dislocation was in 2002, and then the bull market where the energy sector went up 202 percent against MSCI World,” he said, adding “2019 is crunch time.”

Robinson has reduced his holdings in battery firms, arguing the electric car story was “overcooked”, and put money into offshore oil instead.

“An oil price toward the $80 at the end of the year allows the offshore to start again. It’s desperately needed,” he said.

Some of the larger exploration and production (E&P) firms, such as Aker, Lundin and Tullow Oil, which are more sensitive to the oil price, trade at a premium to the sector.

Barclays analysts say these stocks’ performance will depend on the extent to which investors risk venturing out of the bigger oil firms in search of higher leverage to crude.

Miton’s Moore, for example, owns shares in E&P firm Premier Oil (PMO.L) in order to have geared exposure to the rise in crude prices, balancing out his holdings in Shell (RDSa.L) and BP (BP.L), which are less sensitive to it.

Reporting by Helen Reid, Additional Reporting by Ron Bousso and Shadia Nasralla, Editing by David Evans

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