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High energy prices not reflected in energy stock valuations

Market Comment

26/10/2022 • 3 minute read

 
Even though energy prices have surged this year, valuations of energy stocks remain subdued. Appetite for investing in energy stocks has decreased – and we do not expect this trend to reverse in the short term. 

Russian gas exports to Europe have dropped significantly in recent months. This has led to gas shortages in Europe and very high volatility in the gas market, with gas prices reaching historically high levels. Even though the TTF gas price (Title Transfer Facility or Dutch natural gas benchmark) recently dropped from a record high of EUR 340 (intraday) to around EUR 115 (monthly contract), it continues to be very high from a historical perspective. And we expect the gas price to remain elevated for the time being, despite efforts to increase the use of renewable energy, long-term contracts for LNG imports, more LNG supply and government plans to curb high gas prices.

Oil prices to remain high

If we look at oil, we also see a trend towards higher prices. Early October, OPEC+ (Organization of the Petroleum Exporting Countries and other oil-exporting nations including Russia) decided to cut the oil production, despite US pressure on OPEC+ to actually increase production levels. There are currently several factors determining oil demand. On the one hand, recession fears (or an actual recession) lead to somewhat lower demand. On the other hand, the reopening of the Chinese economy – after covid-induced lockdowns – leads to higher demand. All in all, we expect oil prices to rise above USD 100/bbl again and to remain above that level for the time being, due to tight supply. 

Low valuations despite high profits

Oil and gas companies are benefitting from increased prices for oil and gas, as higher prices translate into higher profits. And although the use of renewable energy (solar & wind) will increase, it is expected that oil, gas and coal will still account for roughly 80 percent of the global energy mix by 2035. But despite this forecast and despite the windfalls that oil and gas companies enjoy due to persistently high energy prices, the valuations of energy stocks do not reflect these favourable factors. Admittedly, shares in companies such as Shell, Exxon, Chevron, Total, ConocoPhillips and BP have recovered and performed pretty well lately. But when we look at the valuations of these companies, they look cheap.

Lack of investor appetite

 One of the reasons for these low valuations could be that the market does not see the current energy price environment as sustainable and therefore does not reward these stocks with higher multiples. But probably more importantly, an increasing amount of capital is being allocated to ESG funds (investment funds taking into account environmental, social and governance criteria) which are underinvested – if invested at all – in the energy sector. Particularly integrated oil companies are often excluded from ESG funds (integrated oil companies are involved in both upstream activities, such as exploration and production, and downstream activities, including refining and marketing). 
 
Next to that, investors do not seem to be very interested in the investments that traditional energy companies make to facilitate the shift towards renewable energy production. Some of these investors are unconvinced that energy companies put enough effort in enabling the energy transition. Other investors actually do not want to invest in low-carbon energy production. On top of that, investors had to deal with dividend cuts, as energy companies needed more capital to fund their renewable energy initiatives. 

No impetus for higher valuations in sight

What would it take for energy stock valuations to increase? Managers of ESG funds would have to start appreciating the efforts made by oil and gas companies to shift towards renewable energy production. In addition, investors would have to re-rate energy stocks, based on the expectation that energy prices will remain high for an extended period of time. It might take several years before that is going to happen. We therefore believe that the discrepancy between high energy prices (leading to high profits for energy companies) and below-average energy stock valuations is likely to persist in the foreseeable future. We currently have a neutral stance towards the energy sector.

 
Jan Wirken
Senior Equity & Commodity Research & Advisory Expert

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