Soaring energy prices and fuel shortages are leading to punch ups at the pumps and spiralling bills for consumers and businesses. However, the current turmoil is not bad news for everyone.

The oil and gas sector, which has been a strong performer so far in 2021, is gathering even greater momentum as we head into autumn as natural gas markets reach record levels and oil trades above $80 per barrel for the first time in three years.

Investors may be concerned they have missed any opportunity to play rising oil and gas prices given a strong run for energy stocks in recent weeks. However, we believe there is further upside on offer for two reasons.

First is that investors are yet to see much evidence of this recent surge manifested in companies’ profit, cash flow and dividends. We think as these numbers start to filter through, they will act as a further catalyst for share prices.

The other is that we are still potentially in the early stages of this crisis. We are yet to hit the winter months when demand for gas for heating will rise significantly.

Futures prices imply a UK gas price of 220p per therm in the fourth quarter and 125p per therm for 2022. For context, in February 2021 prices stood at less than 50p per therm.

In this article we highlight four stocks which we believe will be energy winners in the short to medium-term as well as highlighting some funds which offer diversified exposure to this theme.

There are several key risks to investing in oil and gas companies at present. First, smaller operators can often be affected by technical issues which can affect their output. Second, commodity prices can be highly volatile, and this makes profit and cash flow unpredictable. Finally, there is a risk that, given the pressure on public finances and on ordinary consumers, governments look to take a slice of the profit companies are generating from strong energy prices in the form of a windfall tax.

BOOSTING SUPPLY: NOT SIMPLE

While the old adage has it that the cure for high prices is high prices, i.e. demand will reduce and/or supply increased accordingly, oil and gas production cannot just be switched on and off at the flick of a switch.

The combination of a big slump in commodity prices in the initial phases of the pandemic as demand dried up and a shift towards cleaner sources of energy means investment in oil and gas projects has been low.

In fact, this trend has been in motion since the previous oil price crash in 2014 which prompted a wave of industry belt tightening.

Even if the large oil firms turn more aggressive again, it can take years to get a new oil or gas field on stream, so this wouldn’t have any impact on global output for the foreseeable future.

Demand may also take some time to fade, given the emergence from the pandemic has, to borrow Boris Johnson’s analogy, been like the world turning on the kettle at the end of a TV programme writ large.

A CASH WINDFALL FOR BP AND SHELL

The parsimonious approach to spending pursued of late by the likes of BP (BP.) and Royal Dutch Shell (RDSB) means these increasingly streamlined businesses are likely to be generating lots of cash flow at current energy prices.

This looks set to be reflected in their respective third quarter updates on 2 November for BP and 28 October for Shell.

Despite both announcing drastic cuts to their dividends in 2020 both offer attractive yields. The recent strength in both the oil and gas markets creates potential for a positive surprise on the dividend too.

Of the two businesses we see more potential in Shell given its greater focus on natural gas.

Gas accounts for around half of Shell’s total production compared with a much smaller proportion at BP. Shell is also the market leader in a buoyant LNG (liquefied natural gas) market.

Generous dividend yields from BP and Shell

Based on consensus forecasts BP offers a 2021 dividend yield of 4.7% rising to 4.8% in 2022, while Shell is on a 2021 yield of 4% and a 2022 yield of 4.4%.

The current crisis has been caused in part by the inherent unpredictability of renewable energy and while the development of battery storage technology will help, natural gas, as a lower emitting source of energy than coal or crude oil, is likely to play an important role for some time in supplementing solar and wind power.

Small and mid-cap players

The oil and gas universe in London is large, with around 100 different businesses ranging in size from Shell with a market cap of more than £100 billion to Curzon Energy (CZN) at less than £1 million.

One business which has moved rapidly up the market cap ranks in recent months is Serica Energy (SQZ:AIM) which benefits from a large amount of UK North Sea natural gas production at a time of surging domestic wholesale gas prices.

Many oil and gas companies look to make their production revenue more stable by hedging prices through contracts which guarantee a specific price for a commodity. This protects them from any downside but also can limit the upside.

In Serica’s case, hedging has had some impact on profit – with the company booking a £30.3 million accounting loss related to hedging in its first half results (28 Sep). However, some 80% of its projected oil and gas output is unhedged and the company gave a strong hint alongside the recent numbers of a generous full-year dividend to reflect the benefit from commodity price strength.

As broker SP Angel observes: ‘Serica’s production is over 80% gas and the company is already seeing the benefits of increasing production levels at a time of record high wholesale gas prices.’

As well as funding generous dividends, strong cash flow should help the company progress its assets, with the Columbus field (75% gas) expected to come on stream in the fourth quarter of 2021.

Another domestic hydro-carbons producer, Harbour Energy (HBR) looks likely to see a less significant impact on profitability from rising gas prices due to hedging.

Investment bank Berenberg says: ‘(Harbour’s) exposure to the strong gas price environment is limited.’

It calculates that a 5p per therm increase in its second half of 2021 gas price (from a base case of 67p per therm) would result in just a 5% increase in 2021 EBITDA (earnings before interest, tax, depreciation and amortisation).

A smaller North Sea focused firm could be in line to benefit from firmer prices in the near-term as it approaches the point of maiden production. 

On 29 September IOG (IOG:AIM) announced successful results from the latest development well on its Blythe field, keeping it on track for first gas from Blythe and its other field, Elgood, before the end of 2021.

FinnCap analyst Jonathan Wright says: ‘This production will be coming on stream into an exceptionally strong UK gas market, driving material cash flows that will ease any funding pressures on Phase 1 of the development. The finish line is in sight, and IOG is on the cusp of becoming a material North Sea gas producer.’

Based on conservative price forecasts for 2022, FinnCap’s earnings and cash flow estimates put IOG on a price to earnings ratio of a smidge over three times and a free cash flow yield of nearly 34%. This ample cash flow can be recycled into further development of the assets.

A global gas play

Energy shortages and mounting prices are a global rather than UK-only issue. While blackouts might be a nightmare scenario in Britain, for other parts of the world they are a regular challenge.

A company at the forefront of meeting this challenge is Wentworth Resources (WEN:AIM), which owns a material interest in producing assets in Tanzania.

While relatively small and therefore higher up the risk spectrum, we think Wentworth looks attractive on the basis of its stable production and income attractions.

It holds a 31.95% holding in the low-cost onshore Mnazi Bay gas field in Tanzania. Having achieved first gas in 2015, the company unveiled a maiden dividend in 2019.

Based on consensus data from SharePad, Wentworth offers a 2021 yield of 7%. The company achieved record output in the first six months of 2021 and managed to reduce production costs by 72% year-on-year.

This left the company in an enviable financial position with cash of $21 million as of 2 September 2021 and no debt.

As well as enabling Wentworth to fund generous returns to shareholders, it also gives the company the flexibility to go after acquisitions with chief executive Katherine Roe recently telling Shares the current focus would remain on Tanzania in the hunt for assets to acquire.

The main downside to the investment case is the current focus on a single asset in a single country which means the business could suffer if there is a change in Tanzania’s fiscal terms, for example, or suffers a major production outage. However, the track record it has established over the last six years helps to mitigate this risk.

Playing the energy markets through funds

An alternative for investors wary of taking on the risks associated with investing in individual oil and gas firms is to buy a fund which offers exposure to these markets. One option is Guinness Global Energy (B6XV001).

Managed by a highly experienced team who have run portfolios in the energy market since the late 1990s, the fund is up 42% year-to-date but on an annualised basis has delivered a return of -0.38% over 10 years which reflects the volatile nature of the markets it is exposed to.

It has a concentrated portfolio of around 30 stocks which includes high profile firms like Chevron, ExxonMobil, BP and Shell alongside lesser-known names such as Canadian pipeline operator Enbridge, the top holding at 4.7% of the fund. It has an ongoing charge of 0.99%.

Investment trust BlackRock Energy and Resources Income (BERI), which also has exposure to the mining sector, has a better 10-year track record with annualised returns of 4.9% but is also more expensive with an ongoing charge of 1.57%.

Low-cost exposure to commodity prices is available through exchange-traded products such as WisdomTree Natural Gas (NGSP). However, it is worth remembering that if you hold these for the long term your returns are affected by the vagaries of the futures market.

Most commodities are traded in futures contracts. This is the purchase or sale of a commodity agreed at a fixed price for delivery on a specified date – typically either one, three or six months ahead.

This facilitates the buying and selling of the respective commodity without anyone having to take physical delivery of a barrel of oil, for example.

Typically, oil and natural gas trade in a state of contango – a market condition where the price of a futures contract (delivery in the future on a specific date) is above the spot price (the price for immediate delivery).

When contracts are rolled over to avoid taking delivery of the physical asset, contango sees returns diminished.

The impact of contango is more acute for investors in exchange-traded products because the providers of these vehicles do not pay a premium every month to cover the cost of the ‘roll’ and maintain the same position.

In effect the instrument is giving up a proportion of its position to cover the cost of the roll-over. iShares Bloomberg Roll Select Commodity Swap (ROLL) is a broad-based commodity product which aims to mitigate this impact. It has an ongoing charge of 0.28%.

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