Fat Prophets take profits

The Western integrated oil majors have been boosted by higher oil prices which are up by two-thirds since the start of 2006.  However, their share prices have lagged behind as rising costs and the challenge of maintaining and boosting output has been considerable.  With legacy assets in mature areas we believe these issues will remain.  As such we recommend Petroleum and Resources Corporation (PEO) as a sell.

With Petroleum and Resources Corporation (PEO) paying out both income and some capital returns the closed-end fund is an interesting investment vehicle.  Since we initially bought into PEO six years ago in December 2005 (FAT 113, 8^th Dec 05) it has paid back just under half our initial investment back through distributions.

Over five years the fund has outperformed the S&P as the energy shortage theme has proved to be sound.  However, in comparison with the oil price PEO has underperformed and it has also come in short against the DJ Oil and Gas Index.  This is illustrated in the below table:

PEO produced an annualized return over the last five years of 2% which compares to 3.6% for the Dow Jones US Oil and Gas Index.  The expense ratio of around 0.5% is clearly part of the issue but with the Dow Jones index itself underperforming the oil price we believe the key culprit is the exposure to the major integrated oil and gas groups.

WTI Oil since 2006 

Looking at our total return basis and the distributions from the fund have come to US$15.74 since our initial buy of US$32.90 in December 2005.  With the fund currently trading at around US$25.44 our total return over the period is around 25%.

We recommended PEO as a further buy to all members in October 11 (FAT 406) at US$23.30 as equity market weakness saw energy stocks sell off despite strong oil prices.  Both buys given an average entry price of US$27.28.

After printing a low of $20.84 in October 2011, prices have rebounded strongly higher. Major resistance is located at the technically important 200 day moving average of $26.62. This level will no doubt offer firm resistance in the near term.

With reference to the weekly chart, the confluence of resistance is located at the $26 round number. This is made up of the 39 and 200 week moving average. Only a sustained move above both indicators will we see further upside. Should this scenario not pan out, the downside is where we will most likely head to over the coming months.

Looking at the sector allocation of PEO and as of the end of September the group had 35% of the portfolio in integrated oil and gas companies.  Next up is exploration and production which makes up over 20% of the portfolio and the services sector makes up around 15%.

The key holdings have remained similar to when we initially bought PEO (Dec 05) with Exxon and Chevron making up 14% of the fund.  As of September 2011 the two stocks make up 29.1% of the fund. 

For PEO with its income mandate clearly the large integrated energy firms provide a stable dividend return.  However, these companies are also often in mature oil regions and can be bought directly without the need for much active management.

The integrated groups have also often had operations in refineries and petrol chains, which are not leveraged to higher energy prices.  Clearly as well the large integrated groups are some of the biggest Western energy producers and so can find it difficult to maintain output.

A case in point is the largest holding in the fund at 15.5% and until Apple overtook it the world’s largest company.  In the fourth quarter Exxon saw a drop in oil and gas production of 9% even though it has invested US$20bn a year since 2007 to make and develop new energy sources.

In the UK the key integrated majors are Shell and BP with their fortunes having diverged recently.  BP now looks to be recovering while Shell is focusing on achieving output growth targets.  The groups have not been as affected as US peers by increased shale gas production lowering US natural gas prices.

Both groups also have exposure to growing oil regions like Russia and Angola while BG provides exposure to Brazil.  Thus Shell, BP and BG stack up reasonably well against their US peers.

To benefit from the strength of the oil price, though, we believe that a focus on the exploration and production stocks will boost returns.  This is not least as the majors look to do deals in this area to boost and maintain output.

Exxon is apparently looking to move into Kurdistan while in the Falklands a major is likely to announce a tie-up with one of the more promising explorers.  Petroleum and Resources Corporation has not appeared to add extra performance by picking winners in the exploration and early stage production space. 

Summary

PEO has provided diversified exposure to the energy space with a focus on the Western integrated majors which generally operate in safe jurisdictions.  While the fund has outperformed the general market it has underperformed the oil price and the most directly relevant index.

As energy is a long-term theme for the portfolio we would prefer a focus on production and exploration with less emphasis on capital distributions.  Exposure to the integrated groups in the UK can be had through Shell and BP and the FAT UK portfolio also has strong exposure to services stocks.

The real hunting ground for energy investors is the producer/explorers and this is an area in which the London market is fortunate to have some interesting contenders.  We remain optimistic on energy prices noting that estimates are for 30-40% energy demand growth through to 2030 and will therefore look to continue to gain exposure to this trend.

Accordingly, we rate Petroleum Resources Corporation a sell for all members.