2012 was a very tough year for global oil & gas, as the group underperformed the MSCI World by 10%. FTSE Oil & Gas was down 12% and SXEP down 4%.Starting with the disastrous performance of the US onshore-levered oil-field services stocks (the group was down 15% from the March peaks), sharp-sell off in US natural gas prices (-36% to the lows of $1.8/mcf only to end the year in the green) to profit-warnings from consensus top picks, we saw it all. Needless to say, dispersion of returns in 2012 was very high. Looking just at the top 25 oil & gas stocks by market capitalisation (>$40bn), which account for 55% of total global oil & gas market cap, performances range from -23% (Petrobras) to +42% (Ecopetrol).

Despite the volatility in oil prices, Brent finished the year at $112/bbl vs. consensus estimates of $100-110/bbl at the outset of the year, buoyed by rising tensions in the Middle East, persistent problems with North Sea crude production and encouraging macroeconomic signals emerging in 2H12 from the US and China.

Despite such a background, earnings revisions were largely negative for the space. In Europe for example, EPS revisions for the SXEP index were -3% with majors posting the weakest figures and oil-field services stocks helping to improve the picture. In the specific case of integrateds, this further highlights the problem companies have with generating returns even in an environment of high oil prices. Free cash flow (not considering disposals) was negative in almost all majors despite high oil prices.

Going in 2013, there are several themes that are in play:

• Will the US onshore services bottom-out? – consensus is calling for a bottoming in 2H13. While consensus valuation remains cheap compared to average historic multiples, strong performance of the OSX since November 2012 has set a high bar for the upcoming 2013 guidance from companies. Thus, downside risk to estimates still prevails.
• Increased capex in upstream – with upstream capex expected to grow at 8%, upstream is set to continue growing its share in the total capex mix. This is why we prefer exposure to subsea and seismic (not vessel owners though).
• Will increasing US shale oil production change the nature of the global oil & gas markets? – while the global impact is yet to be seen, we are confident that the changes brought by the increased US production domestically, most notably the WTI discount to Brent, are structural. This opens up opportunities for different sub-sectors, from E&Ps focused on riding this wave, infrastructure roll-out necessary to support this production to the impact on refining margins we saw in 2012.
• Was the refining boom a one-off or is it sustainable? – strength in refining margins, shutdowns on an unprecedented scale (including those related to the Petroplus bankruptcy), a year of heavy maintenance, unplanned outages and delays to certain high profile expansions (Asian refining margins were the exception). Due to the unlikely nature of a combination of all of the factors, we do not believe that such margins would be sustainable in an environment of weak demand that we are seeing.
• Challenging production profiles, high required cash flow breakeven oil prices and requirement for stable growth pushed by high pay-out ratios of the integrateds will drive M&A in production growth, lower geological risk E&P stories.

As such, we see a strong environment for cash-rich, high growth exploration companies focused in Africa and US shale. Also for EPC contractors with focused operations and low barriers to entry, as well as underwater drillers centered in the premium segment and with no distracting diversification activities. We continue to avoid supermajors as free cash flow compresses and growth challenges prevail, and look opportunistically at emerging market exploration-only small caps.