As featured in this month’s Master Investor Magazine.
August 2015: in which your correspondent introduces a mysterious old actuary known as “No. 5” and talks of the prospects for oil and gas shares BP and Royal Dutch Shell – finding the ‘value investing’ fundamentals significantly compelling, amidst all the emotion and panic coming like the sun, out of China across the bay – to quote Kipling.
One of the longer established denizens of our little Limpopo River fraternity is an old actuary (actuaries seem to live longer on average, thus violating the profession’s own tables of mortality which they apply to the rest of us). He inhabits a sturdy, plain, functional bower near a plantation of Bongo Bongo trees.
He may be spotted in the evenings with an old, hand driven, mechanical Monroe calculating machine that looks a bit like a cigarette rolling contraption, working out the average age of an idealised defined benefit pension scheme, which exists only as an intellectual hypothesis in the tunnel vision of his actuarial brain, which is long practiced in doing probability and discounted cash flow calculations internally.
It is an interesting statistical fact that most of humanity has never met an actuary. Except the lady in the local bakery who proudly told me only this week that her niece is training to be one. How is that for unexpected obscurantism?
I would like to introduce our old actuary to you by name, but he refuses to divulge it, preferring to be known as number 5 only; mistrustful, as he is, of an identity made of mere letters and words and wishing to merge himself as completely as possible into restful numeracy of actuarial science.
“Just call me ‘5”, he says, with a faraway look in those old, faded blue eyes. The only concession he ever made to normal human entertainment was to once watch recorded episodes of “The Prisoner”, in which the hero (the late and wonderful Patrick McGoohan, who is now regrettably beyond even pensionable age) is addressed as a number, in his encaged, potty world of surreal captivity, from which it is impossible to escape. Naturally, our ancient actuary took to the surreal world of the Limpopo with much aptitude. Like ‘yours truly’, he enjoys surreally consuming roast beef and Yorkshire pudding, prepared by an African cook, beneath a southern African sky.
Number 5 is a refugee from that now lost golden age of civilized retirement made possible by the final salary pension scheme. His philosophy – as he explained one evening, over a meal of Umbopo’s splendid roast beef, Yorkshire pudding, roast potatoes and Brussels sprouts, followed by breadpudding – is based on the notion that hell is other people and that the best refuge from them is the lone existence of the consulting actuary, who mostly deals with numbers and, thankfully, not people. If it is true that he is one hundred and nine years old (as is rumoured), it is wholly in defiance of actuarial mortality tables and at a significant cost to his pension scheme sponsored by his old firm of actuarial advisors and employers Messrs “Likely and Approximate partners”.
Like many consulting actuaries, he has sat on the advisory boards of pension funds pronouncing on the investment policy of their investment managers. He has been correct with astonishing consistency about investments but sometimes with hindsight. (How many of us have not been one hundred per cent correct, after the event, when everyone is a winner!?)
As he sits, consuming his third pint of fermented coconut juice, I ask him, “Number 5, what are you investing in now, in this great share price slump?” He leans towards me and replies, “The ‘winners’, my dear man; winners!”
How wise and correct? I think to myself. He then adds, “Think always in the long term if you want to make real money.”But in the long term, are we not all dead” I reply, having read my John Maynard Keynes’s ‘Theory on Prices and Employment’. “Exactly!” says Number 5. “It is just before that event – retirement – when you need the assets. “Look at the unwashed and unloved shares of the market place, where everyone has heard the bad news several times over and there is decent income while you await a recovery,” he adds.
“Is it easy to identify such companies?” I ask. “No!” he replies. “That is why is why you should not put all your savings in one basket (or share) – along with the eggs”
No. 5’s view on oil major shares
Will the crude oil price keep on heading down?
The Saudi Arabian position: It became evident last year that Saudi Arabia, which has the second largest oil reserves on the planet, is following a policy of preserving its share of the market; presumably, as some argue, because it recognises that hydro-carbons are increasingly being replaced by renewable sources of energy. We have all been blinded by the fact that the Saudis have such large reserves and such a low cost of production, and have forgotten to ask questions about their government’s financing needs. There is the easy and understandable assumption abroad that the Saudi government has tons of money, well in excess of the needs of a country with a small population. Comparatively, it is a small population but one that has grown by six million over the last ten years, to around 30 million now.
That easy assumption was challenged by the fact that in July the Saudi Arabian government joined the queue in the international debt markets this month. It has raised $27 billion for government spending; a story that made the front page of the Financial Times, which commented that the policy of low oil prices has put a strain the kingdom’s finances. National debt per capita is low at a reported $857 per head, versus per capita GDP of around $22,160 per head. It has unemployment of around 6%. In short, now that oil prices have fallen, partly as a result of Saudi policy since last year, its government needs to borrow, and it has a rare capacity to do that.
Saudi Arabia reportedly needs a price of $105 per barrel to finance its national budget expenditure. Moreover, it has just reduced production from around 10.5 million barrels of oil per day to 10 million barrels of oil per day. Although this was justified by reduced domestic oil demand in the autumn (less need for air conditioning to keep those 30 million Saudi Arabians cool in summer) it was nevertheless an action slightly out of character. One assumes that as a very low cost producer, it could have sold that extra 500,000 barrels per day at a lower price and still made operating profits. The fact it did not chose to do so, along with its new role as a debt raising nation, may mean that it wishes to go no further in pushing down the crude oil price and return to a more traditional role of managing its price through controlling levels of output. The borrowing may be a straw in the wind.
The return of the Persian Lion: Iran will be returning as a major supplier over the next year or two, as its recently unused oil fields are brought back to technical and economic efficiency. If that means weaker prices, then there will presumably be less fracking and deep sea production, which are high cost operations by comparison. We are seeing big oil companies cutting back on such costly exploration for costly oil production. The industry worldwide is seeking a new equilibrium – the economist’s word for balancing production and exploration in relation to price. (One awaits a call for Alex Salmond to apologise to the Scottish people.)
The shrinking China dragon: The main problems in people’s minds about oil had been Saudi Arabian production and the awaited return of Iranian production. We now add to those concerns less demand from China, making matters even worse. But the old serpent of economics is a dynamic creature; it bites and then slithers to bite elsewhere.
Objectivity: Panic has set in. Does the investor now join in and sell his shares or think about adding to his investments if he has the cash? Here are some good reasons for adopting the latter course:
1) An investment in oil shares is not the same thing as buying crude oil. The dominant characteristic of equity investment is that you are investing in people; the managers of the company. They are paid to anticipate events (not always easy to do) and strengthen the company against deteriorating in the face of them. The combination of management action along with a decline in the share price has a tendency to improve the outlook for a share pretty quickly. That dynamic, I suggest, is already evident in oil shares.
2) The crude oil price in any event very volatile, as history shows. Between 1973 and 1974 the price of oil rose 300% from $3 per barrel to $12 per barrel. A quick inspection of an oil price chart will show this truth about its volatile nature very clearly. In 2010 highly paid, all seeing, investment bank economic oracles were predicting that the price of oil would soon rise to $150 per barrel. Look at what has happened to it since.
3) The world economy is not in the state that the stock exchange panic indicates. The biggest economy in the world is still Uncle Sam’s, and that has recovered and is doing well. Europe is showing signs of post glacial economic improvement and is expected to grow more than people thought likely a year ago. China is as a matter of fact far bigger than it was this time ten years ago. It is a source of significant demand and potential future demand as it continues the difficult and painful process of growing domestic demand for domestic and overseas goods and services. That said, it clearly cannot keep growing at the sort of rate we have come to expect as it becomes so large. That is a significant change in terms of purchasing power for the new, increasingly domestically driven China. Oil will play its role and you can bet your bottom dollar that oil industry managers will have diversified and rationalised to acclimatise themselves profitably to changes.
4) Remember, too, that UK and US equity markets have had a long recovery and run from recession. They had ceased to look obviously cheap and the fidgety hedge fund managers with billions in the bank (there is a limit to the number of status indicating watches you can buy or bottles of fine wine you can swallow) were much more likely to short that situation than buy it. Moreover, this is summertime when markets are thin. Rapid reaction panic and markdowns tend to hold sway over calm objective thoughtfulness, at such times.
So I suggest that oil companies are well worth looking at on these occasions. If the valuation fundamentals look right – as they certainly do, I suggest – then this is a time to buy not sell. Remember big institutions will be thinking exactly in this way, with a view to averaging their historic book costs. When the market reaches a dreaded and awaited big bearish event, it is usually the time to buy.
BP (BP.) at 336p after the results for the six months to 30th June 2015
The BP share price at 336p (last seen) is about 31% below where it was at this time last year. The FTSE 100 fell 11% over the same twelve months. In the previous December, 2013, the shares had been priced at 384p. BP is a big company with equity currently valued at just over £67.5 billion. It is too big to ignore, but it has been a dismal investment over the last few years. As a result of the Gulf of Mexico problems, as well as the collapse in oil prices, the BP share price over the last five years is down over 10%. Over the same five year period the FTSE100 Index rose 18%.
The good news for BP is that the Gulf of Mexico is now history, so far as liability is concerned. Finally BP is out of the grasping fingers of America’s ‘good ol’ boy’ claimants, who in plundering the coffers of BP – without proof of loss in many cases – displayed all the opportunism of old time Cornish shipwreckers. Now that, it seems, is finished. The company has settled too with the Federal agencies of the USA. The Gulf of Mexico disaster is history.
Now BP is having to grapple with a much lower oil price. It plans to do that by some big cuts in investment and a rationalisation of the business; the sorts of things that company managers do on occasions like these. But does it have the time and the money? And can it keep on paying the dividend, which at time of writing yields 7.6% historic and last year cost $5.8 billion to pay? Is that dividend unsustainable or is the share price too low if it is?
First and foremost, the latest cash positions reported by BP in their published accounts look encouraging. At the year end, the cash position was a reported $30 billion; in the June accounts that had increased 9% to a reported $32.8 billion. That is 5.6 times the cost of last year’s annual dividend payment. On an annual basis, operating cash flow last year was $32.75 billion. Capital spending, which had been $22.5 billion last year, had dropped to $9.2 billion in the first half of the current year; evidence of the management’s intention to cut out investment spending, at a time when doing such a thing seems supremely logical, possible and desirable. A balance sheet depleted of a chunk of $22 billion of unnecessary investment spending is going to be a much healthier balance sheet capable of funding the shareholders’ dividend receipts.
On the question of cash flow, I point out BP is now selling on only 7 times last year’s depreciation charge; around 3 times last year’s gross cash flow and 3.5 times last December’s year-end cash in the balance sheet.
It is also valued (at 336p a share last seen) at very close to net attributable assets. These were shown as worth $106 billion in the June balance sheet – which I estimated on the basis of an exchange rate of 1.55 dollars to a pound. On that basis, the UK share price of 336p is supported by 325p of net assets.
So, having had a look at the latest accounts, what does the market think in terms of consensus earnings and dividend forecast estimates? Basically, the market in its expert collective wisdom, reckons that after last year’s 83% fall in earnings, we are in for a positive change. The consensus estimates an 85% increase in earnings this year, and another 23% increase next. Also expected is a modestly progressive dividend payout. In short, the current market consensus estimates put the shares, at 336p, on a prospective 13.8 times earnings estimates for this year and 11.2 times those estimated for next year. There are prospective dividend yields 7.3% for this year and next.
If I were still a fund manager, I would be averaging down my position at this stage, hoovering up the shares of those foolish enough (or hard pressed enough) to be selling them.
Royal Dutch Shell (RDSA) at 1,620p
The following comments are based on a share price of 1,620p after the great late August share markets collapse. Royal Dutch Shell, the Anglo-Dutch oil and gas company, is on a historic dividend yield of 7% and a PER on reported figures of 12 times earnings. As with BP, it is a handsome dividend yield. Can it be sustained in times such as these? Or is the share price telling us that the market is expecting it to be cut (a usual prognosis of dividend yields at this level)? So amidst the sell off panic of late August, is Royal Dutch Shell equity oversold?
The share price has come down from a five year peak of 2,475p nearly a year ago. Over a year, therefore, the share price has come down by about a third, falling much further than the FTSE 100 Index which dropped about 11% over the last year. Interestingly, over the last week and month its share price has performed only slightly less well than the FTSE 100 market.
Subjecting the Royal Dutch Shell accounts to observations similar to those employed above for BP, one sees that the annual dividend last year cost Euro 9.44 billion. You may reasonably put that cash cost against year end 2014 cash holdings of Euro 21.6 billion and even better, an operating cash flow for last year of 45 billion Euros. Although it is conventional to speak of earnings cover for dividends, it is cash held and produced within the company that is key, because it means money going out of the business.
On these figures, the historic annual dividend cost was covered strongly by cash held; that is to say by 2.3 times on the basis of the last December’s year-end cash figure, and 2.8 times by the cash held figure at June 30 (cash held having increased from Euro 21.6 billion in December 2014 to Euro 27 billion by June 30th 2015).
So is the market expecting no earnings growth and a cut in the Royal Dutch dividend? Unfortunately, I am unable to tell you that, because my usual market source does not have such consensus estimates available at the moment. My instinct, given the strength of the last and penultimate (annual) balance sheet is to suppose that when they appear, they will at least show an expected holding of the last annual dividend.
Recent advice from the company talks of an unchanged share buy-back programme with a planned 10% reduction in operating costs in 2016 and Euro 7 billion cut in investment in 2016. The company is, conservatively, planning for several years of weak oil prices by restructuring itself through a Euro 20 billion sale of assets during 2015/16, which the company states it is able to achieve even in weak markets. It also states that its significant new projects are designed to produce material cash flow and free cash flow in the medium term.
I look for No5 and see him beneath the moon with his hand-driven calculating machine working out the life and death calculations for the eternal final salary scheme model he carries in his head. He has left me a message: “Both BP and Shell look significantly oversold and should play a profitable part in any long term portfolio of shares”.