The energy sector is attractively valued and under owned, according to Willem Sels (pictured), UK Head of Investment Strategy, HSBC Private Bank. Moreover, it appears that earnings momentum and earnings revisions are finally improving. In addition, improving cash flows and better management discipline should make the sector more appealing going forward…
Following many years of high investment spending the energy sector now seems to be focussing on capex discipline and cash generation. The high levels of cash flow available in the sector should, in our view, trigger share buy-backs and cause dividend payments to rise across the sector, supporting total returns for shareholders.
The energy sector is trading on a price-to-book ratio below 1.5x, which represents a valuation discount of more than 20% to the wider global market. Also, the sector has been unloved for some time, with global investors substantially underinvested.
New innovations in hydraulic fracturing and new drilling technologies have led to the shale revolution, particularly in the US, which is well on its way to becoming energy independent. Moreover, these new innovations have helped to significantly increase energy companies’ productivity in recent years.
Another supportive factor for the energy sector is the new focus on growth in cash flow from operations rather than on capex. In our view, this is likely to be a key driver in improving free cash flow going forward.
Low valuation and disappointing performance have persisted for some time now, mainly driven by negative earnings trends. However, the pace of downward revisions has slowed relative to the wider market, and expectations now appear reasonable. Furthermore, improving earnings surprises may finally become a catalyst for a re-rating.
We expect the energy sector to outperform going forward, thanks to improving earnings revisions, better capital discipline and hence improving free cash flow trends.
As for risks, a sharp fall in global growth could weigh on energy demand. Environmental issues could also impact margins. And finally, as always in this sector, regulatory risks remain.