Scottish Investment Trust : The Contrarian Case for Oil

So far this year, oil has been distinctly out of favour. The MSCI ACWI energy sector has fallen some 11% in 2017(1), and Brent crude has officially entered a bear market earlier in the year. Although the oil price has risen from its trough of early 2016, when it fell as low as $28 per barrel, the revival has petered out. Optimism about concerted action to reduce the supply glut has also subsided, as OPEC's recent cut agreement has failed to eliminate the surplus. Meanwhile, Libya and Nigeria are threatening to offset the fall in output elsewhere. And the future of OPEC's deal with Russia is already in doubt.

Nor is the outlook for US supply any rosier. The number of rigs operating in US fields has more than doubled over the past year. Many shale wells have been taken offline because of the oil-price slump, but these can be rapidly brought back online - sometimes in as little as a week. Thanks to cost restructuring and improvements in well technology, shale producers can now pump profitably at $40 rather than at $65, as previously. That could constrain any potential oil-price upside, because the shale producers can jump back in as soon it becomes profitable.

To most investors, all this gloom is a signal to stay away. The consensus is that the oil price will be low for the foreseeable future, and so oil companies are unwise investments. The aversion also has an ethical dimension, as a focus on sustainable clean energy sources is discouraging investment in fossil-fuel producers.

At The Scottish, we love consensus. We just don't like to be part of it.

Market consensus provides contrarian opportunities. It can be uncomfortable to stand apart from the herd, but it's where the greatest rewards are to be found.

And we do see opportunities in oil. We believe investors are overlooking the world's reliance on fossil fuels. Just because a commodity is plentiful doesn't mean that it isn't necessary. What matters to the producers is not so much the oil price, but their ability to stay competitive - and profitable. The oil-price slump has already flushed out many weaker operators. So, the surviving companies have come through some ferocious natural selection. Operationally, the oil majors are more fit for purpose than they have been for 20 years.

Patience may be needed while valuations recover. But investors are paid to wait. The oil sector offers compelling dividends, with the six largest oil firms all paying out 4% or more.

We also think that ethical concerns will abate, because the oil companies are taking their environmental responsibilities increasingly seriously. Exxon, for example, has joined a climate-leadership council. And all of the large oil companies have signalled their disapproval of Donald Trump's decision to pull out of the Paris Agreement.

Ultimately, everything is cyclical - and oil is no exception. The world's reliance on fossil fuels will see the sector through its current tough times. In the meantime, we are confident that companies that have weathered the downturn can reap the benefits when the oil price recovers.

(1) As at 31 August 2017.

Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations. You may not get back the amount you invest.

The Scottish Investment Trust PLC has a long-term policy of borrowing money to invest in equities in the expectation that this will improve returns for shareholders. However, should markets fall these borrowings would magnify any losses on these investments. This may mean you get back nothing at all.

Investment trusts are listed on the London Stock Exchange and are not authorised or regulated by the Financial Conduct Authority.

Please note that SIT Savings Ltd is not authorised to provide advice to individual investors and nothing in this promotion should be considered to be or relied upon as constituting investment advice. If you are unsure about the suitability of an investment, you should contact your financial advisor.