Is the oil rally for real?

A series of drops in US oil inventories and the announcement that OPEC’s late-September Algerian summit could lead to production cuts are boosting the oil price, which is back above $50 a barrel.

This is good news for any investors with oil exposure in their portfolio, either directly or indirectly, and may even benefit the whole UK equity market.

Brent crude is poking back above the $50-a-barrel mark

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

While investors are unlikely to have the time or inclination to get involved with the details of individual stocks, they will be aware that oil majors BP and Shell are two of the biggest stocks in the FTSE 100 and therefore two of the most influential constituents in terms of profits, dividends and therefore the benchmark’s ultimate trajectory.

This suggests that in some ways, the higher the oil price goes the better it is for the FTSE 100, at least in terms of earnings and particularly dividends. 

The FTSE 100 is forecast to yield around 3.8% in 2016 and 4.0% in 2017 but one lingering concern is that earnings cover of those dividends at 1.5 times this year and 1.7 times next year is well below the 2.0 times comfort zone.

This is at least partly because two of the biggest dividend payers - Shell and BP - offer cover of barely 0.5 times in 2016 and 1.0 for 2017. 

Dividend cover for the FTSE 100 overall is higher excluding the oils, but the higher the oil price goes, the more comfort investors can draw from both the overall FTSE 100 dividend yield and dividend cover forecasts, as well as the estimates for the two oil giants.

FTSE 100 offers a decent yield but earnings cover is thinner than ideal

Source:Digital Look, Consensus Analysts' forecasts, Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

A skilled fund manager will earn their corn picking out the safe (and growing) dividends and dodging the potential cuts. 

The good news is there are plenty of funds which target equity income from the UK. Working out whether you are happy to target those with high or low oil exposure will be a matter of your personal taste, but to add to the usual array of statistics below, we have added three columns, which show the energy sector weighting and whether the fund has BP or Shell in its top 10 holdings list, according to the latest factsheet.

Best performing UK equity income funds over the last five years

Source: Morningstar, for UK Large-Cap Blend Equity category, plus fund providers' factsheets. 
Where more than one class of fund features only the best performer is listed. 
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Best performing UK equity income investment trusts over the last five years

Source: Morningstar, The Association of Investment Companies, for the UK All Companies category, plus fund providers’ factsheets
* Share price. ** Includes performance fee 
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Will oil be back?

As the market action of the last decade attests, predicating the oil price is a bit of a mug’s game.

The price of Brent crude has been very volatile for the past decade (and beyond)

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Demand may be relatively steady, for the commodity seems to be surprisingly price inelastic, but supply comes with a huge number of variables. These include 

• Technological changes (such as the rise of shale oil and deepwater drilling) 
• Geopolitical developments (such as civil unrest in Iraq and Libya or the strained relations which persist between Shia Muslim Iran and Sunni Muslim Saudi Arabia)
• The economic requirements of key producers who may desire a certain price level to balance their sovereign budgets (notably Russia, Venezuela and Saudi Arabia).

September’s OPEC summit in Algeria is a case in point. Doha’s April meeting had failed to deliver production cut and hopes were low going into this get-together as Iran and Saudi Arabia seemed unwilling to reach an agreement, only to then apparently do so.

Even now doubts linger about whether the proposed deal will ever actually be implemented. OPEC is still saying that the details of the production cuts have yet to be agreed and will only be finalised at November’s next formal summit in Vienna.

Slick checklist

While the complex politics of OPEC are far from easy to follow, they are potentially important for those investors in UK equity funds, active or passive, let alone those with any direct exposure through individual stocks or tracker products which follow the oil price.

As the charts below show, the energy sector (BP and Shell) are forecast by consensus to generate 8% of the FTSE 100’s pre-tax profits in 2016 and 19% of its dividend payments. For the record, these figures are 15% and 23% for 2017, again based on consensus analysts’ forecasts.

Oil stocks represent a large portion of the FTSE 100’s forecast aggregate earnings

Source: Digital Look, consensus analysts’ forecasts.

Oil stocks represent a large portion of the FTSE 100’s forecast aggregate dividend payments

Source: Thomson Reuters Datastream

Above and beyond OPEC summits, there are three more tangible themes which investors can follow, if they are weighing up the pros and cons of exposure to oil-heavy indices (like the FTSE 100) or equity income funds (which may or may not have a sizeable position here).

• US oil inventories. These can be tracked every Wednesday via the website of the US Energy Information Administration. Oil inventories have decreased for four consecutive weeks and gasoline inventories six times in the last nine weeks – although do note that the aggregate figure is still up by around 7% year-on-year. The tighter inventories are in the world’s largest economy going into the winter season, the better it could be for oil bulls.

US oil and gasoline inventories are creeping lower

Source: US Energy Information Administration. Excludes Strategic Petroleum Reserve.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

• US rig count One key feature of the last two years has been how the oil majors have become much more conscientious when it comes to cutting costs. Consultants Wood Mackenzie assert that $1 trillion worth of exploration projects have been cancelled out to 2020. This supply-side discipline, at least partially enforced by lower oil prices, reduced cashflow and the need to protect shareholder dividends, can be seen in the US operational rig count provided weekly by oil services giant Baker Hughes. 

From a high above 1,900 in 2014, the number of active rigs collapsed to barely 400 by this spring. It has since rebounded to 508 (still enough for a one-third year-on-year decline) and bulls of oil will be hoping the capital investment is kept tight and rig activity subdued to underpin crude’s latest rally. A big surge in the rig count could potentially be seen as a negative development.

US oil rig activity had plunged though it has started to increase once more

Source: www.bakerhughes.com/rig-count
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

• The international rig count. Published by Baker Hughes on a monthly basis, this dataset shows a similar trend to the US numbers, namely a huge collapse in activity. At the trough, the number of active rigs was down by some 45%, although, as in the US, activity has begun to pick up again in the last couple of months.

International oil rig activity collapsed though it has started to increase once more

Source: www.bakerhughes.com/rig-count
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Russ Mould, AJ Bell Investment Director.