Investor - An insider's guide to the market: One of the key distinguishing features of 2006 is the global rise in 10-year and longer-dated government bond yields that has occurred since the beginning of the year.
Although yield rises have been quite modest, last week witnessed a psychologically important milestone as the 10-year US treasury bond broke through the 5 per cent yield level for the first time in almost four years amid worries that inflationary pressures could force interest rates higher than expected.
Euro-zone yields were also on the rise with the 10-year Bund almost touching the 4 per cent level, which is close to an 18-month high. Even Japanese bonds flirted with two-year highs as its 10-year benchmark bond came close to a 2 per cent yield.
While these yields are not particularly high in a historical context, it does now appear that global bond markets have made a decisive break from recent years when yields on long-dated fixed-interest securities remained stubbornly low, even after short-term interest rates had begun to rise.
At least the 2006 rise in bond yields is consistent with broader economic and financial developments. Current yields can be fully justified by current trends in global economic growth and commodity prices and, indeed, further rises would seem to be warranted. Bond yields, therefore, are following these broader trends and, as such, are not having an adverse impact on other assets. In fact, up to recently, bond yields looked anomalously low, particularly in view of the potential threat posed by booming commodity prices.
One area where there does seem to be a valuation anomaly is in the oil and gas sector of the UK stock market. In today's environment of rising commodity prices, and particularly rising oil prices, one might expect that stocks such as BP and Royal Dutch Shell would be star performers.
Surprisingly, the share prices of the integrated majors have been somewhat quiescent in recent years and, despite a good performance over the past month, they have actually lagged the overall UK equity market.
This is reflected in below-average market valuations. For example, BP trades on a price earnings ratio (p/e ratio) of 11.7 and a dividend yield of around 3 per cent. The entire UK oil and gas sector is trading on a p/e ratio of 11.4 based on projected 2006 earnings. This is a large discount of approximately 25 per cent to the median p/e ratio of the main FTSE industrial sectors and compares with a p/e ratio of 14.7 for the Irish equity market.
Such a low rating flies in the face of what would appear to be extremely favourable market conditions. Higher oil prices boost the profits of oil and gas companies and this has been happening during the current economic cycle.
However, oil prices are extremely volatile and could revert closer to their long-term average over time. This volatility in the oil price has transmitted to the share prices of energy companies in the past. It is therefore not too surprising to find investors are taking a jaundiced view of current high levels of profitability, believing that such profits are vulnerable to a decline in the oil price.
A second negative factor impacting oil company share prices is that it is becoming increasingly difficult and expensive to discover new reserves of oil and gas. Royal Dutch Shell lost substantial credibility in recent years when it was forced to admit that it had overestimated the volume of its oil and gas reserves.
The company has since implemented major governance and management reforms in order to regain its status with investors and analysts. Replenishing depleting reserves is now a key goal of all of the integrated oil majors. Despite the above caveats, the current share prices of the UK oil majors imply that the current oil price is unsustainable.
If, over the course of 2006, the oil price stays at or close to the current level, however, there could be a significant re-rating of the UK oil and gas sector.
In Investor's view, the two UK majors, BP and Royal Dutch Shell currently offer good long-term value based on p/e ratios and dividend yield. The shares would probably hold up well, even if the oil price declined back to the $50-$60 (€40.45-€48.55) range, and they offer substantial upside if the oil price sustains current levels.
