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The Risk Sandwich: Why I Have Been Selling Down My Oil Major Holdings


Recently I have been selling down my RDS.B and BP holdings due to fears I have about a risk sandwich.

Though the current risk from an oversupplied market I'm comfortable with, as a long-term investor I have a bigger issue with what I see as the longer-term risks.

Here I explain where I see the risks and why that is making me move out of my holdings.

Oil majors represented among my earliest and biggest investments. I'm sure I'm not the only investor to be in the situation of stating that. Digging up and selling a commodity which is so visible to us in our everyday lives they often come to mind quickly to even the most inexperienced investor.

With remarkable cash flow generation (whether enough to service their dividends or not) and usually hefty dividend yields their appeal are transparent to all. And their yield are certainly impressive:

If you put together an equally-weighted portfolio of just five international oil majors - Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B), BP (NYSE:BP), Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX) and Total (NYSE:TOT) - you'd emerge with a portfolio generating a very nice 5.4% yield. The appeal of this to investors including myself is, naturally, immense. Consequently, even with the massive fluctuations in share price of late, my two oil major holdings of Royal Dutch Shell and BP had generally constituted between about 8% and 10% of my total portfolio weight. In terms of dividend contribution, this share was much more sitting at around 15%. It was, therefore, hardly a small part of my investment universe.

Yet in mid-July I sold down my oil major stakes significantly. They now constitute no more than 3.5% of my portfolio and 7% of my dividend income. I had the good fortune of doing so at pretty much their recent peak and making a nice profit in the process. However, I'm not yet done and nor do I plan to buy back into them anytime soon even if the prices do fall. Indeed, I expect my holdings to come down even further in the near future. Why? Well it is chiefly derived from fears regarding what I see as a risk sandwich for oil companies:

Here I'm going to take a little time to explain what I mean. I don't expect many if any of you to agree with my reasoning in its entirety. However, I set about writing this to understand the topic better myself in order to make a better informed long-term decision. I look forward, in turn, to hearing your own thoughts on the matter.

Current Oversupplied Market

Let's start off with the first part of this "risk sandwich" which, naturally, remains the most discussed threat to the oil majors. There are several reasons why I will not be discussing this part in too much depth here. First is the above point: it is well covered by people more knowledgeable than me with regard the oil market here on SA. Second, because as a long-term investor this does not unduly worry me as a threat. Nonetheless, it is important to cover it.

Essentially it boils down to the fact that, right now, we have pressure on the industry created by oversupply. The worrying aspect for the integrated oil majors is not just that oil prices are down due to this oversupply, but also gasoline levels are at hefty levels too (data source: EIA):

In the past, integrated majors could generally sit comfortably when oil prices dropped their refining margins and were lifted and vice versa. In any oil market, therefore, they could generally be relied upon to match a headwind with a tailwind. The attractions of this are hardly difficult to emphasize. Recently, however, the tailwind is not currently doing what it was expected to do as high gasoline levels are depressing refining margins. As BP explained their Q1 2016 results:

The global refining marker margin averaged $10.50 per barrel in the first quarter, the lowest since the third quarter of 2010, weighed down by weak diesel demand and high gasoline stocks in the United States.

The situation had not improved by their Q2 results either:

The global Refining Marker Margin averaged $13.80 per barrel in the second quarter, the lowest second quarter since 2010. It compares with $19.40 per barrel a year ago and $10.50 per barrel last quarter, reflecting some seasonal recovery. However, we expect high product stock levels to continue to keep industry refining margins under pressure.

Not great news. Yet as I note later, I do expect them to return to a more benign market in the near term with the respective boost to their share price and financial stability. Yet, for me, I have become increasingly concerned not by the immediate-term risk (which remains, but which I'd be happy to sit out) but the longer term risk. Let me explain what I mean.

Long Term Consumption Pressures

As a long-term investor, this is a critical factor. I'm still (just) under 30 and so hope to have a healthy handful of decades for my investments to serve me. Yet, over the years, my investment style has increasingly focused on high compounding businesses. Companies with massive, reliable cash generation and competitive advantages which look strong and (most importantly) sustainable form the core of this strategy. Sustainable here, of course, I mean less in the environmental sense and more in the simple longevity sense (though, naturally, the two are not mutually exclusive).

Why? Well, quite simply because these are the sort of businesses that really reward long-term investors. You can buy into them and let their compounding do the work. In turn you develop long, multi-decade relationships with the businesses in your portfolio. Ideally I want to pick the kind of quality companies which I can buy today...