The oil and gas industry contributes to 42% of global emissions according to global consulting firm McKinsey.

It is little wonder that the sector has found itself in the crosshairs of environmental campaigners and a growing portion of the investment community is turning away from fossil fuel-based investments amid increasing focus on environmental, social and governance (ESG) issues.

At the beginning of this year the CEO of asset management giant BlackRock, Larry Fink, was vocal in committing his organisation to putting climate change considerations at the heart of its investment strategy. Others are likely to follow suit.

This raises the prospect of oil and gas fields becoming ‘stranded assets’ – resources that once had value but have since become a costly liability.

If capital shifts out of oil and gas shares it could create a vicious circle for the sector whereby their weighting in global indices decreases and they are therefore less widely held by tracker funds.

In this context, why would you continue to invest in oil stocks like BP (BP.) and Royal Dutch Shell (RDSB)? It’s a big question that many investors are now asking.

We think there are several reasons why they still might appeal to someone comfortable with any ethical considerations and the long-term challenges facing the space. Oil is under pressure but we still think it could be a good source of investment returns in the near-term.

HYPOCRITICAL STANCE?

Fink’s comments drew fire from environmental campaigners who pointed to the inherent hypocrisy in BlackRock’s new stance given its position as one of the largest global investors in the resources space.

And Fink himself admits: ‘Despite recent rapid advances in technology, the science does not yet exist to replace many of today’s essential uses of hydrocarbons. We need to be mindful of the economic, scientific, social and political realities of the energy transition.’

Charles Luke, fund manager of Murray Income Trust (MUT), is one of the many institutional investors that still have exposure to the oil sector as a source of income. BP is under pressure from critics who say it should stop spending so much on dividends and redirect that money into renewable energy investments, thereby accelerating the transition away from a traditional oil and gas focus.

However, he comments: ‘It is not clear to me that BP will have to cut the dividend to fund its growth in renewables.

‘There is a middle way to do both things. It is conscious of the long term threat to oil but is also slowly transitioning the portfolio to a more renewables future. Typically it will need to invest in areas of the market where returns are lower and less guaranteed.

‘It would be difficult to generate the yield for Murray Income Trust without having some oil and it would be difficult to have a diversified portfolio without having some oil.’

FOUR REASONS WHY OIL COULD STILL DELIVER

We see four reasons that oil could still deliver positive returns for investors for at least another few years.

– DIVIDENDS

As Luke’s comments allude to, the UK’s oil majors pay very generous dividends. At the time of writing Royal Dutch Shell and BP yield 6.5% and 6.4% respectively.

Shell hasn’t cut its dividend since the Second World War but BP’s track record is less spotless – it temporarily suspended the payout in the wake of the Gulf of Mexico oil spill a decade ago.

Together they account for around 10% of the dividends paid by all UK companies. Shell is promising to pay out around $125bn between 2021 and 2025 based on its current cash flow projections.

We believe there is still strong demand from income funds in the short to medium-term to continue buying shares in the big oil companies despite concerns about the industry from an ESG perspective.

– IMPROVING OIL PRICE OUTLOOK

Oil has retreated from the multi-month highs above $70 per barrel attained amid rising tensions between the US and Iran as both sides seemed to step back from the precipice of outright conflict.

However, some observers see reasons to be positive on the oil price in the short-term. Canaccord Genuity analyst Charlie Sharp says: ‘We believe the increased supply-control commitment from OPEC, declining US shale output growth and Chinese economic stimulus look capable of offsetting some production expansion elsewhere.’

Sharp adds that the relative stability in the price in the second half of 2019 will have been supportive to firms’ ability to make long-term investment decisions.

Investment bank Berenberg also has a positive view, saying: ‘In our view, the risks to oil prices have started to be skewed more to the upside following the further OPEC cuts agreed in December, combined with downward revisions to the US shale production outlook.

‘We still expect a surplus market in 2020 but that surplus is considerably smaller than our previous forecasts. It is also weighted to the first-half, shifting into a deficit by year-end.’ For the investment bank this feeds into a $65 per barrel oil price assumption for 2020 – exactly in line with where the commodity price is trading at the time of writing.

– CAPACITY TO ADAPT

Although ESG and oil and gas might seem entirely incongruous, there are things the resources industry can do to reduce its impact on the environment.

The indirect emissions from the use of fossil fuels is something which is out of companies’ hands. However, there is scope to reduce the emissions generated in the course of their operations.

Management consultant McKinsey has pointed to several things oil and gas producers can do. This includes using renewable energy on-site, reducing methane emissions by improving leak detection and repair, limiting the burning or flaring of gas by increasing operational efficiencies, and using carbon capture technology.

– THE DEATH OF THE OIL AND GAS INDUSTRY HAS BEEN EXAGGERATED

The growth of the electrical vehicle industry is seen as an existential threat to the oil and gas sector, with road transport accounting for upwards of 40% of all oil demand.

The transition from traditional combustion engines to electric vehicles is unlikely to be smooth or happen overnight. Oil consumption may be growing less quickly but it is still going up and there are lots of other uses for oil, such as petrochemicals production and fuel for the aviation or maritime sectors.

BACK TO $100 OIL?

The recent Middle East crisis stirred by the US killing of top Iranian general Qasem Soleimani led to some speculation on oil reclaiming the $100 per barrel mantle.

If Iran were to shut the Strait of Hormuz – out of which a third of the world’s traded oil flows – it might prove a sufficient catalyst to drive oil to that level. However, this seems an unlikely course of action as it would be almost sure to provoke ever more severe retaliation from the US.

The Middle East has been responsible for most of the big spikes in oil going back decades. In 1979 the Islamic revolution in Iran created a panic in the oil market and on an inflation-adjusted basis saw oil prices trade above $100. Oil hit a record $147 in June 2008 on Iranian missile launches. Six months later it was at $32 amid global recession.

The last time oil traded above $100 per barrel was June 2014 when the ISIS conflict in Iraq was at its height. This preceded a plunge in oil prices linked to the rapid growth in US shale production and global growth concerns which eventually saw prices bottom out around the $20 mark in January 2016.

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YOUR GUIDE TO FTSE 350 OIL STOCKS

Royal Dutch Shell (RDSB)

Market cap: £178bn. Forward PE: 11.5

Shell is an integrated energy business. This means it has operations in oil and gas exploration, production, marketing, refining, transportation and distribution. In a nutshell it is involved in everything from drilling and finding new sources of oil and gas to selling you petrol at the pump.

In recent years the company has been investing in natural gas projects – gas being cleaner than oil and other fossil fuels – as it attempts to respond to pressure over climate change and changing patterns in energy consumption.

 

BP (BP.)

Market cap: £100.8bn. Forward PE: 11.9

Like Shell this is an integrated operation, running the gamut from exploring for hydrocarbons to selling and marketing its own refined products. Under CEO Bob Dudley, who steps down in February 2020, the focus has been on becoming a more streamlined organisation, change driven in part by the impact on the company of the Gulf of Mexico oil spill in 2010. All told the company has sold around $60bn worth of assets in the interim making it a leaner and more cash generative business.

 

Energean Oil & Gas (ENOG)

Market cap: £1.55bn. Forward PE: 17.9

Among the better performing oil and gas shares in recent years, Energean listed on the London Stock Exchange in March 2018. The company is developing resources in the Mediterranean. The focus is on natural gas, which makes up 80% of the portfolio.

The company’s flagship development assets are the Karish and Tanin fields located offshore Israel. The plan is to commence production from the Karish field in 2021 when total group production is expected to hit 140,000 barrels of oil equivalent per day.

 

Cairn Energy (CNE)

Market cap: £1.15bn. Forward PE: 24.3

The company has been embroiled for several years in a tax dispute over its historic assets in India. After an unsuccessful and expensive exploration effort offshore Greenland the company has enjoyed renewed success in the waters off Senegal where it recently gave the green light to the Sangomar development.

The field is expected to produce around 100,000 barrels of oil daily. First oil is targeted in early 2023. Cairn also has producing assets in the North Sea, where its key assets are the Kraken and Catcher fields.

 

Premier Oil (PMO)

Market cap: £976m. Forward PE: 11.6

Since the oil price crash in 2014 Premier has been wrestling with heavy levels of debt. A recent court ruling means it can move ahead with a plan to extend the maturity of its borrowings and acquire North Sea gas fields from BP despite opposition from largest creditor Asia Research & Capital Management (ARCM). As well as buying up its debt the latter has been short selling Premier shares as a hedge.

Premier now needs to secure the approval of its other lenders to progress the plan. Selling its Zama discovery in Mexico could contribute to fixing the ongoing balance sheet problem.

 

Tullow Oil (TLW)

Market cap: £751m. Forward PE: 7.2

The last decade was ultimately a miserable one for Tullow. In the noughties it had gone from small cap status to an established constituent of the FTSE 100 off the back of big discoveries in Ghana and Uganda.

A more patchy exploration record in the interim, and production problems as these African finds have been brought on stream, allied to volatile oil prices and too much debt have proved a toxic mix.

In December 2019 the shares lost more than half their value as Tullow suspended its dividend, slashed output guidance and saw chief executive Paul McDade and exploration boss Angus McCoss depart in ignominy.

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OUR TOP OIL PICKS

RockRose Energy (RRE) £22.08 BUY

The company’s strategy has been built on buying assets in the North Sea at attractive prices and then investing to extend the life of these assets.

This has the advantage of boosting reserves and output as well as forestalling decommissioning liabilities. For example, the production life of the Ross and Blake fields has been extended from 2024 to 2029 under its ownership.

The success of this approach is reflected in the fact that the share price, in just a few short years, has gone from 51.5p to £22.08. We still think there could be more upside to come.

The company has built a large, cash-generative portfolio – the Marathon acquisition which completed in July 2019 has a particularly significant impact – and has returned a significant chunk of this cash to shareholders. Average production is expected to total 21,000 barrels of oil equivalent per day in 2020.

Growth opportunities through M&A activity could include buying into new fields as well as upping interests in existing fields, with the company sitting on cash of $370.7m at the last count.

RockRose is also drilling seven development wells in 2020 which could act as a catalyst for the shares. A commitment to pay out 85p per share in dividends for 2019 implies a yield of around 4%.

Jadestone Energy (JSE:AIM) 83p BUY

The brains behind this Asia Pacific oil and gas play have an impressive track record. In particular chief executive Paul Blakeley who, at Canadian outfit Talisman Energy, built a business which became the UK North Sea’s second largest operator with upwards of 160,000 barrels of oil equivalent per day production.

He then moved to Asia and delivered a business on a similar scale for Talisman before the group was bought by Spain’s Repsol in an $8.3bn deal in 2015.

In both cases Blakeley’s strategy involved hoovering up unwanted assets from major oil and gas companies. Jadestone is pursuing a similar approach.

Having already picked up assets in Indonesia, Australia and Vietnam its latest acquisition in November 2019 was the $50m purchase of the Maari field in New Zealand from Hungarian firm OMV.

Investment bank Stifel spells out the attractive metrics of this deal: ‘We estimate $74m free cash flow net to Jadestone across 2019 and 2020 – having generated around $40m free cash flow in 2018 net to OMV – so the field is very likely to have paid for itself even before the transaction has completed.’

Blakeley tells Shares that the region is attractive as it is ‘energy hungry and has a low cost profile’. The company plans to pay out up to $12.5m in dividends in 2020 which would add up to a prospective yield of 2.6%.

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