Oil Stocks: A Risky Bet or a Wise Investment?
In a world where geopolitical tensions can send shockwaves through markets, the question on many investors' minds is whether the recent rerating of oil and gas stocks is a sustainable trend or a fleeting response to the Gulf hostilities. This is a crucial dilemma, especially considering the historical precedent of such conflicts.
The Middle East Conflict: A Historical Perspective
Recalling the 1991 Iraq war, we witnessed oil prices soar to $120, only to plummet once supply security was restored. While it may have felt advantageous to hold oil shares and cash during that initial surge, the medium-term gains were less impressive compared to simply holding steady or buying during the subsequent dip.
The Current Crisis: A Different Scenario?
Fast forward to today, and the warnings of $100 oil if the Strait of Hormuz becomes compromised are no longer just warnings. Iran's Revolutionary Guard has issued a dire threat, stating that all ships attempting passage will be set ablaze. Surprisingly, oil prices initially remained relatively stable, perhaps due to modern traders' lack of memory of the 1973 oil embargo and its devastating impact on inflation and fuel queues. However, Brent crude has since risen 3.3% to $80.30, reflecting the complex dilemma at hand.
A Self-Fulfilling Prophecy?
The situation is further complicated by the likelihood that US/Israeli air attacks will take significantly longer to establish ground security, especially considering Iran's widespread proxies, such as the Houthi rebels, who have resumed attacks on shipping in the Red Sea corridor. This has led to insurers withdrawing their support, creating a self-fulfilling prophecy of sorts. With a fifth of global seaborne oil and liquefied natural gas (LNG) passing through the Strait of Hormuz, along with a third of the world's urea trade (the most widely used fertilizer), this is a worst-case scenario for the global economy, and it's likely to escalate before it improves.
Inflationary Pressures and Monetary Policy
Higher inflation, possibly even stagflation, looms as a very real possibility, presenting a significant dilemma for monetary policy. The OPEC oil cartel's agreement to a modest rise in output from April offers little solace, especially given the recent shutdown of Saudi Arabia's largest domestic oil refinery after an Iranian drone strike, and the precautionary closure of other oil and gas facilities across the Middle East. This situation bears striking similarities to the 2019 drone strikes on Saudi facilities by Houthi rebels.
The Role of Oil and Gas in Balanced Portfolios
Despite the ethical concerns surrounding the environmental impact of oil and gas, we are witnessing why these industries have long been considered a necessary hedge. A circa 20% rise in oil prices this year, even before the current conflict began, underscores the oil market's sensitivity to global events. While related shares initially lagged this rise, the reality of supply disruption has caused share prices to surge. Tullow Oil (LSE:TLW) was London's biggest riser, up 20% yesterday, due to its high indebtedness, which makes it more susceptible to material changes in oil prices.
Small Caps vs. Big Oil
Small-cap companies like Tullow and EnQuest (LSE:ENQ) have been in a relative bear market compared to BP (LSE:BP.) and Shell (LSE:SHEL). However, the big companies have coped better in the recent low oil price environment, as the sense of excess supply and demand disruption, exacerbated by rising global tariffs, has taken its toll. If energy prices remain elevated, initial inflection points in small caps may offer more upside potential.
Valuation Criteria and Contrasts
Basic valuation criteria vary significantly, particularly in the small-cap space. BP, trading at 493p, has a 12-month forward price/earnings (PE) ratio of 14.5x, a 5.2% yield, and is nearly at 2x net asset value (NAV). Shell, at 3,152p, has a 13.1x PE, a 3.6% yield, and is at 1.4x NAV. In contrast, Tullow, trading at 13p, has a 6.6x PE, a zero yield, and a negative NAV due to its net debt of around £1.7 billion. Enquest's net gearing, while less extreme, is still around 200%, and the company trades at 1.3x NAV with a 3.8% yield. However, it is expected to be loss-making in 2025 and 2026 due to North Sea windfall taxes. The question remains: Could elevated energy prices change this outlook?
Establishing a Portfolio Hedge: The Challenge
Hedging at current prices is a complex task. If the worst-case scenario of stagflation unfolds, oil and gas shares will likely see profit-taking as energy demand falls. If the war proves short-lived, as the US administration anticipates, oil prices will retreat. However, it's unclear whether air bombardments alone can restore shipping security. Even if the Revolutionary Guard capitulates, Iran's proxies may remain well-fueled by their hatred of the West.
Logistical Challenges and Limited Alternatives
Furthermore, even if OPEC increases output, there are no real logistical alternatives to the Strait of Hormuz. While two pipelines run across Saudi Arabia, one is at capacity, and the other could accommodate an additional two million barrels per day, compared to the Strait of Hormuz's transit of 18 million. Another pipeline across the United Arab Emirates can handle just under two million. This lack of alternatives highlights the chronic disruption that could persist.
Preparing for the Worst-Case Scenario
Given the ideological motivations of the antagonists involved, I believe we must prepare for a worst-case scenario of chronic disruption. Stamping out actions by proxies will be challenging, and insurers are likely to maintain a firm stance. BP and Shell will appeal to professional investors, and their focus on quarterly relative performance figures may drive a trend towards big oil as a portfolio hedge. I would, therefore, apply a medium-term "buy" stance to both. Small caps, especially Tullow, given its potential status change regarding debt risk, offer more leverage and appeal to speculators.
Tullow: A Speculative Bet with Past Hazards
I took a speculative "buy" stance on Tullow at 45p in September 2021 and again at 34p in January 2023 when a director significantly increased his holding. He continued to do so, last buying £238,000 worth at 11.9p in August. Over 2025, he purchased a total of £468,000 worth of shares and currently holds 28.3 million shares, or 1.92% of the company. On the short side, Helikon Investments is the only hedge fund involved, with a determined 1.85% exposure, which it raised by 0.43% last November.
A Sensitivity Analysis for Tullow's Future
As the saying goes, "the tide in the affairs of men..." a major shift towards sustained higher oil prices could now swing Tullow's fortunes in a favorable direction. Properly determining this requires a capable sensitivity analysis of various oil-price scenarios. The recent expectation of around £42.5 million equivalent net profit in 2026 and earnings per share (EPS) of around 2p suggests a tipping point for earnings, especially with Tullow's improved leverage.
EnQuest: Building on Market Favor in 2026
In contrast to Tullow, Enquest has conservative financial criteria, with nearly £1 billion equivalent free cash flow generated since 2021, aiding debt de-leveraging. The introduction of dividends from the 2024 financial year further reduced risk, helping the shares rise from 10p in January ahead of a robust February operations update. However, a near-term loss-making scenario appears likely due to the extension of the UK windfall tax to 78% on oil and gas producers. Operational issues, such as a third-party infrastructure outage a year ago, and EnQuest's pivot towards its Malaysian interests, which will involve costs and time, add to the challenges.
A Long-Term "Buy" for EnQuest?
My sense is that the UK is likely to end up with a coalition government unable to change North Sea taxation, so I am not inclined to invest in EnQuest. However, if Reform delivers on its pledge to improve oil and gas, and Nigel Farage becomes prime minister, EnQuest might be a long-term "buy." There are currently no short positions over the 0.5% disclosure threshold.
Conclusion: A Speculative Stance
The logic of an oil and gas supply crisis, I believe, is a distinct possibility. Therefore, I retain a "buy" stance on these stocks. However, it's important to note that a speculative run could be subject to reversal if the disruption is significantly resolved. As always, investors should carefully consider their risk tolerance and seek professional advice before making any investment decisions.
