Oil prices remain very subdued, in a recent range of between $40 and $50. Despite this there has been a significant recent rally in the oil majors’ shares.

In the long term it is realistic to expect that demand for oil will be subdued, given that its share of overall global energy production is declining with substitution taking place from alternative energy sources. Hence our view that oil prices are stuck, with their lows governed by a level at which supply reduces materially, and the upper level set where expensive new resources such as shale become viable.

The recent Saudi announcement, that they are considering international bond issuance, really brings home the level of stress caused not just to the corporate sector but also Middle Eastern governments from currently low oil prices. This has the classic symptoms of an oversupplied market experiencing stress. It is therefore reasonable to expect that high cost marginal producers will start to reduce supply, removing some of the downward pressure on prices. This process is clearly taking place, with a number of high cost long term projects recently being scrapped.

These are some of our data points. What is the narrative? There has been much talk of the possibility of dividend cuts from the oil majors. Clearly this is a possibility, but what is the more probable scenario? Despite making operating losses in recent quarters, these companies have huge cash flows before capital expenditures. Expectations of dividend cuts reflect the expectation that these companies will continue to make unprofitable investments in high cost projects despite a low oil price. While possible in the short term, in the long run this seems unlikely.

So if we value the businesses on the basis that management behave rationally and only invest in profitable projects in the long term, then there are two possibilities. If the oil price remains low, capital expenditures will continue to be cut and cash flow will support the dividend in the long run. If the oil price rises and capital expenditure remains at current levels, operating earnings rise materially. It seems you cannot have it both ways.

As we see it we have a gap between the data and the narrative for the big oil stocks which have relatively low costs of production, and the affirmation, whilst early, seems to be evident in the recent outperformance of the stocks. We have made some tentative investments in the sector on this basis.

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