Sector Spotlight: Consumer Staples
April 15, 2021
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Gaby Gourgey: Hello and welcome to today's discussion. My name is Gaby Gourgey, and I'm the institutional portfolio manager of the MFS European research strategy. I'm delighted to be joined today by my colleague James Neale from the European equity team, who covers the energy sector. We are witnessing some really astonishing disruptions across the energy markets, which have even resulted in the spot price for oil turning negative for a brief period. Do you think you could comment on the reasons for this and share some of your thoughts about how the forces of both supply and demand have shaped the current environment?
James Neale: This has been an amazingly interesting year for oil markets in particular. What we're witnessing I think is the end of a long cycle for oil that began back in 1998 with the collapse of supply and demand. Then it peaked in 2008 when we got oil prices up to $140 a barrel. And I think what's happening to this year is that you're going to see an even bigger collapse in demand first and then subsequently supply, caused by the COVID-19 situation. I think the point about what's happening today is that, just like in 1998, what's happening this year is going to lead to some permanent adjustments to the oil supply and demand picture. And that's going to shape how the next long energy cycle will play out.
To give you some picture of how badly demand has been impacted by COVID-19, in April of this year, demand was down by 30 million barrels a day. That's 30%, and that's quite an incredible reduction in demand. And it's almost impossible for supply to adjust to that overnight. And in fact, the first reaction from OPEC earlier in the year was to try and increase production! So the problem of adjusting supply to meet demand is starting off in a very, very difficult place indeed.
My view is that even if we experience a recovery later in the year in demand, you could well see that 2020 demand will be down around about 10 million barrels a day versus last year. And what this means of course is that storage for oil is going to fill up globally in the next two to three months, maybe even sooner in some places. Certainly the US is looking fairly close to full. And what that leads to is a situation where the physical market sees very, very limited demand and that resonates back into the financial of paper oil markets where the challenge for someone who owns a contract in all of is pretty much to avoid having to take delivery of the actual barrels.
And that was the interplay that occurred last month when you saw oil prices in the WTI contract - the West Texas Intermediate contract - go to a very steeply negative price. Now, of course we think that maybe that was a one off, but the reality is inventories are still getting fuller, and you could see that happen again in June or July or even August if we're not careful.
GG: Which I'm guessing will create a yet more dislocation. So in this environment, when we think about how these integrated businesses have navigated the last cycle, is there anything that we can take away that is going to help inform our views looking forward? What have we learned about big oil companies over the last 20 years?
JN: The reality is that when the oil price is $20 a barrel or $25 a barrel, up to 10 million barrels a day of oil supply globally is losing cash at this time, so it can't really survive this kind of lower oil price environment for a long period of time. And I think for the big integrated oil companies, the problem is they have a lot of that production. So it's been a fairly difficult time for those companies to adjust to this situation. The last cycle for oil and gas was a big disappointment for the integrated oil companies. It started with huge optimism at the start of the cycle with the mega mergers back in the early 2000s, but actually what occurred subsequent to that was they ended up seeing declining returns as they moved up the cost curve for oil. Over the last six years, the returns for the oil companies were permanently below their cost of capital. And that was before we got to the adjustment that we've seen in 2020. You saw no growth in organic EPS over the course of the cycle and there was no structural production growth either.
What you did get, however, was a very big dividend. The problem with that was that only 30% of it, on aggregate, was paid by their cash flows and the rest of it was being paid from divestments and an increase in debt. So the sector really begged and borrowed to keep paying its dividend over the course of the cycle. And as we've seen in 2020, the tide has gone out and these companies have found themselves in a bit of trouble.
GG: Against that very severe dislocation, how do you assess which companies are going to be able to withstand these somewhat extraordinary pressures?
JN: All of these companies have had to negotiate their way through energy and oil price down cycles in the past, so they will pull a lot of the same levers that they tried to put in the past, but they will have to in a more severe way this time. And those leavers are: you cut capex very aggressively, you look at taking the dividend down - you've already seen a couple of companies cut their dividend - and you cut costs. The problem of course with the oil and gas sector is you have this problem of decline in geological asset, and because of that, if you could cut capex today, you end up digging yourself a hole for the future. So it's always a big trade off for them.
In times like this actually, you find yourself working a lot more close to your fixed income colleagues because one of the problems for big oil now is that because they had to pay their dividends to some degree out of raising new debt - never a good idea really (!)- they've gone into this downturn with a much more leveraged balance sheet than in previous downturns. And for that reason, if you work with your fixed income colleagues, they can help you a lot with looking at who has the most onerous maturities in the near term. You can better assess liquidity issues and in general they can help you a lot with seeing the warning signs for some of these companies. I think the truth of the matter is that some are going to get through this better than others, and that relates to how successfully they adjust their cost base, but also to the underlying profitability of their businesses.
GG: So when you start to look forward, are there any reasons to invest in integrated oil for the next oil cycle? How do you think about sizing opportunities looking ahead?
JN: It's a very good question because these companies have been such poor investments for quite a long period of time now. And that poor performance makes sense - declining returns, declining growth, etc. I think the reality is that over the course of this crisis, a lot of the management in the sector needs to rethink the operating model that will be required coming out of this cycle. I think personally they've only got a couple of choices. The first one is to very, very seriously now embrace the sustainability model. And that means getting off the dividend bandwagon, to be allowed by financial markets to be the agents of energy transition towards a lower carbon energy future. And the problem at the moment is that the market seems unconvinced by these strategies, and it's rerated the utilities companies and wants them to lead the transition rather than big oil.
I think the second strategy they might need to think about, and you are starting to see some signs of some companies doing this, is the embracing of a liquidation strategy. And what I mean by that is you think about this as maybe being the last hydrocarbon dominated energy cycle. The sector could then think about trying to follow the sort of tobacco sector model and realize value through that means. And that would be through a commitment to reducing investment, running down assets, targeting, returning, let's say 100% of their EV over the next 10 years from the monetization of their hydrocarbon resources. Now what this does is it removes terminal value risk. It removes stranded asset risk and creates value for shareholders as well. It seems to me a strategy that could be very appealing to investors in the sector, and it's certainly one that you started to see a couple of managements start to think about.
GG: One of the issues with the long-term viability of these companies in the economic landscape is this politically charged debate around CO2 emissions. Do you think this is something that these companies are going to have a good answer to in terms of their brand going forward?
JN: I think they do need to have a good answer to it, and my perspective is that the oil and gas sector needs to be incorporated into the renewed energy transition of a global economy. If not, the burden is going to fall entirely to the utility sector and that means ultimately to the taxpayer.
And so when the big energy companies wants to embrace this transition, it seems very paradoxical to decide not to allow them to do that. That's why, when I see certain moves to disinvest conventional energy from portfolios it seems to me to be shortsighted actually, because I think we underestimate how long it will take to remove hydrocarbons from our day to day existence. I think we risk removing a key potential driver of the transition if we don't allow big oil - who have very big project management skills that they've shown over multiple decades - to help lead this transition.
So, I guess 2020 might be the moment where you get the reset, and I think forming the narrative for the energy transition coming out of this is going to be very, very interesting. But it's certainly a turning point in this sector.
GG: And lastly, when you think about entry points and triggers, could you comment briefly on how you think about valuation in the next cycle?
JN: As with any other sector, the key drivers of whether this becomes a good investment or not is what the returns on capital look like and those risk adjusted returns relative to the growth profiles of the business. And frankly they just haven't stacked up in the last cycle, which is why we've basically seen energy as an underperformer for such a long period of time.
In fact, energy as a percentage of the broad market indices has consistently shrunk and more than halved over the course of the last decade. The first point is to see where you think returns are expanding, where those returns are maybe undiscounted in the current share prices. But actually with this sector, it's more looking at how company management is are thinking about deploying capital. These managements have deployed capital seemingly poorly over the last long cycle. After this reset, there have to be serious thoughts about whether you can deploy capital for the benefit of the underlying equity of these businesses. And I think this is why thinking about either a liquidation strategy or a sustainability strategy make a lot of sense in this sector.
GG: James, thank you very much for your time this afternoon and your thoughts about an appropriate strategy for the coming years in this sector. And we look forward to continuing the discussion as to later date.
JN: Thank you.
The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.