Companies

Africa ex-SA Equity Fund: Finding value in Nigeria

The first quarter of the year was particularly volatile. The Africa ex-SA Equity Fund closed unchanged for the quarter, masking substantial intra-quarter moves and sector-specific contributors and detractors.

Amongst the industrials, Eastern Tobacco contributed strongly but this was offset by Delta Corporation’s 20% decline. Similarly our Nigerian oil stocks performed well as the oil price recovered to US$40 per barrel (/bbl), but their contributions were offset by continued weakness in the Nigerian banks.

The oil story

The Fund is exposed to the oil market through its investments in Nigeria’s Seplat, as well as indirectly though the Nigerian banks. Sentiment towards the oil market is very poor: commentators who in July 2014 thought the oil price would remain steady above US$100/bbl are now calling for the price to remain below US$40/bbl. While we are the first to admit that forecasting commodity prices is extremely difficult, we do have a view on the oil price, which is premised on sustainability and the business cycle.

When the oil price was over US$100/bbl, oil companies were investing all their operating cash flows and borrowing from very willing capital markets in an effort to grow production as fast as possible. This type of behaviour is usually an indication that the status quo will not last. Two years later we are in a situation where almost all oil companies are generating negative free cash flow despite cutting capital expenditure as fast as they can. Over 90% of US oil companies generated negative free cash flow in 2015 despite the oil price averaging US$53/bbl compared to today’s US$41/bbl. Furthermore, many US companies realised an oil price well above US$53/bbl due to hedging gains. 

An indication of how capital is being withdrawn from the industry is the number of rigs actively drilling for oil, as reported by oilfield services company, Baker Hughes. In November 2014, 3 670 oil companies were drilling around the world; and as of the end of February 2016, this had reduced to 1 776, a 53% decline. Most of the decline was in North America, but the number of rigs drilling in the rest of the world still fell 23%. In time we think the reduction in capital expenditure will manifest itself in a tighter market and higher oil prices. This is despite all the talk of Saudi Arabia and Iran ramping up production.

We currently aren’t modelling the oil price returning to its previous highs, but if it does we won’t complain. Fortunately Seplat, our largest oil exposure, offers good value at the current oil price and higher prices offer further upside.

But it’s not all about oil

The Nigerian stock market is very weak as the naira/US dollar peg is unsustainable and the economy is fragile. Nigerian bank share prices are pricing in a greater than 50% chance of bankruptcy. We think most of the banks will survive and some will thrive as the Nigerian economy is not only about oil. We have taken this opportunity to invest in what we think are quality franchises at very depressed prices. We think these prices more than compensate investors for the currency and economic risks. Again, a higher oil price will help the Nigerian economy but we don’t think it is required to make the Nigerian banks very attractive investments.

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