A Pursuit of Alpha- How to Identify Value in ASX-Listed Oil & Gas Stocks?

A Pursuit of Alpha- How to Identify Value in ASX-Listed Oil & Gas Stocks?

Summary

  • Crude oil prices have recovered over 172 per cent from the April 2020 lows to now trade above USD 43 per barrel (Brent).
  • The surge in crude oil prices is presently diverting the attention of the market towards oil stocks, which in the recent past have witnessed a sentiment splash.
  • Amidst all the fuss and market fears, many market participants are hunting for value in ASX-listed oil & gas stocks.
  • But, how to identify value, what tools are at the disposal of retail investors, and how to generate alpha in the middle of such unprecedented market conditions?

Crude oil prices are under gush, and every uptick in the oil price is diverting the attention of the market towards oil stocks, as they closely monitor the trajectory led by oil prices. Brent crude oil prices have recovered over 172 per cent from its April 2020 low of USD 15.98 per barrel to presently trade around USD 43.18 per barrel (as on 9 July 2020 12:35 PM AEST).

The surge in oil prices across the international front has recently led towards a sentiment splash in ASX-listed oil & gas stocks, which at present seems to be diminishing with many prominent names such as Woodside Petroleum Limited (ASX:WPL), Santos Limited (ASX:STO), Senex Energy Limited (ASX:SXY) again tumbling on the exchange.

Amidst all the fuss and market fears, many market participants are hunting for value in ASX-listed oil & gas stocks, as behemoth companies are relatively trading lower.

But one question that could arise in a retail investor’s mind is, how to identify value or seek alpha in the middle of the market turmoil.

The pursuit of alpha requires in depth analysis, and the investors have two broad approaches at their disposal- technical analysis or fundamental analysis, with many more sub-divisions within these two approaches. It is usually seen that an investor undertakes either one or the combination of both to seek alpha in the market and bag some returns.

Technical Filtering

While there are a lot of technical tools available at the disposal of an investor, we would use some more commonly used filters, as the basis of technical analysis lies in the concept of commonality, i.e., the more the people act on the same signal and basis to reach a decision to buy, sell, or hold, the more successful would be the signal; however, such signals are often lagging.

  • Moving Averages Crossover

Moving average crossover is the most commonly used signal to identify a change in trend, and many traders use it as a first filter to shortlist stocks. While moving average crossover is a very successful filter, it is always lagging, and the value of averages being considered varies considerably among traders.

The right way of using a crossover is to analyse the price pattern and then determine the length of your average period of study. You surely do not want to use a long-term average on a short-term price graph to determine the trend or any changes in it in the short term.

In the case of ASX-listed oil and gas stocks, as prices have corrected recently, a trio of 200-day, 50-day and 21-day exponential moving averages could be one appropriate combination out of thousands of possibilities.

In such trio, which includes one long-term, one medium-term, and one-short-term average, the long-term average is used to identify the primary trend while the pair of medium- and short-term averages is used to navigate the fluctuation in prices and identifying possibilities of a potential future move.

A stock trading below its long-term average is often in a downtrend, and a stock trading above its long-term average is often in an uptrend. Furthermore, if the medium-term average trades below short-term average, it is considered as a positive crossover and vice versa.

As mentioned above, while crossovers are the most commonly used and strong signals, they are often lagging, which in turn, leads to late identification of a change in trend. However, once identified, it could be given a higher probability that the signal is not false.

The lagging issue of moving averages could be refined further by combining results of moving averages with oscillators such as Relative Strength Index, Stochastic indicator. Thus, it is one way to apply technical tools in identifying the potential of value.

Furthermore, even moving averages could be converted into an oscillator by detrending the stock time series and could be used to identify value while removing the lagging nature. For example, a ratio of moving average with that of the current market price of a stock could be calculated on a real-       time basis and on the historical data to draw a mean. above or below which value could be easily identified and resonated into returns, if applied cautiously.

Fundamental Filtering

Fundamental filtering takes the financial position of a company into consideration rather than its price action to identify value, and there are thousands of fundamental combinations an investor can deploy to filter stocks to identify value and generate alpha.

Falling P/E and Strong Dividend History

For example, one strategy is to calculate the trailing price-to-earnings ratio of a stock and check it against the trend of dividend yields and buyback history to reach a decision and spot alpha. Many investors look for low price-to-earnings ratio and a rising historical trend in the dividend to reach a buy decision as low P/E implies lower price paid as compared to the earnings, which coupled with the history of high dividend payment further transcends into margin of safety.

Relation of Oil & Gas Stocks With Crude Oil

Crude oil price forms a major factor in deciding opex and capex of oil & gas businesses,  over the long-run, as for being a raw material, it dictates the profitability of a refining company operating in the oil & gas sector.

While for refiners crude oil adds to the cost of raw material for oil producers, it dictates the profitability in terms of the selling price of their product. Likewise, a majority of gas contracts derive their reference price from the market price of Brent crude oil. Thus, crude oil is regarded as the major influencer of profitability for companies operating in the oil & gas sector.

Oil, WPL, STO, SXY Daily Chart (Source: Refinitiv Eikon Thomson Reuters)

For reference consider the above chart, in which, it could be seen how ASX-listed oil & gas stocks are closely monitoring the change in Brent crude oil prices.

However, slight divergences in crude oil prices and stock prices could be seen on the chart, which are mainly attributable to the beta of such stocks and their fundamental position in the market.

Furthermore, a strong hedge book of a company operating in the segment can also create such divergence, and one should become familiar with such fundamental aspects.

A hedge book is typically a list of contract which a company operating in the oil & gas segment secures early to either deliver or receive a product on a future date at a pre-determined price. Such hedge books somewhat keep companies safe from small-term fluctuations in the oil market; however, even the long-term a drastic change in the oil market often leads to re-negotiation of the contract, if not secured over the exchange, as it increases default risk.

Conclusion

Every strategy and combination of them used to generate alpha have their own pros and cons or let us say risk and reward, which one should always become familiar with before deploying them on a real-time basis.

To Know More, Do Read: Oil Crisis: Should you Buy or Sell Some Oil Stocks?

In a nutshell, such tools are always at the disposal of an investor, and one can utilise them to identify and filter oil & gas stocks and for that matter any segment of the equity market, which could help in generating alpha.

 


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