The after-shock effect of cheap Oil prices

Why the slash of investment from major players today is creating a shock wave to be felt over the next years at service companies and how to take advantage of the situation

Fortune Tellers

If you have been following the news over the last six months, probably you have arrived to the conclusion that the slump of the Oil prices in the markets have caught by surprise not only the general public, but as well people with deep connections and experience in the business of trading it, Oil producing companies, banks and investors, who did not see it coming.

After almost five years of pretty stable high Oil prices for producers, and consumers not complaining too much either for the high fuel prices, this situation created an status quo of confidence which encouraged major Oil companies and venturous entrepreneurs to invest huge capital and resources into developing more costly production projects, certainly expecting acceptable revenues for their shareholders and investors. In parallel, governments with national Oil companies (NOC´s), have been surfing over a nice and big wave of cash, which was been utilized in very different ways, such as the examples of Saudi Arabia or Venezuela.

But this situation has changed drastically over a small period of time and the plumb in revenues for NOC´s and major Oil companies have lifted a red flag on the markets , who are still trying to figure out what caused the depreciation of the value of the black gold. Some find explanation in the speculation from Oil traders, others blame oversupply by recent inventories from shale Oil production, while some others point out the slowdown of China´s economy and Europe´s lack of growth.

Most probably the cause is a mix of all these scenarios, in proportions that will never be fully understood. What is clear is that the Oil Industry is a really complex matrix, where the prices are the result of several factors interlocked in a way that makes the prediction of the market to look like an obscure art of fortune telling...

The Biblical 7 year Cycle

On the bright side of this situation, some economists are cheering this cheap Oil price scenario as the right boost for the global economies to consolidate the (so expected) growth. Promises of lower fuel and energy prices are beneficial for stimulating the consumption and keep the money flowing.

However, over the last week we have seen published the yearly results of the listed major Oil companies with significant profit and revenue losses, as expected, when compared with the previous year. For example, ExxonMobile and BP are reporting 20% drop in profits and Shell, although has reported a quite acceptable 8% profit drop, is announcing an investment cut of $15bn over the next three years. And this is just the beginning. We can expect more spending cuts from major Oil companies and NOC´s if the current Oil price is sustained under $50/b during 2015.

Of course, this is what you would expect from a good management and corporate governance of Oil companies trying to protect the profitability and investment of shareholders, but also brings to the equation the question of the impact on the market due to lack of investment.

It has been long know to economists, that commodities have a cyclic behavior when it comes to their trading, and Oil and its derivatives are no exception to this trend. Actually, a look to the the last 10-year of WTI historical prices will reveal that this is the third plumb of prices below $45/b over this period. So in average, it seems that Oil markets follow the Biblical curse of the “seven years of plentiful, seven years of famine”.

Clearly, there is a more rational explanation for each one of these low points and spikes in the prices. But generally speaking, they are strongly related to the supply and demand market conditions. Take for example the year 2008: the first half was marked by Venezuela´s threat to cut of sales to ExxonMobile due to legal battles over the nationalization of ExxonMobile´s assets in the country, stop of production in Iraq due to terrorist acts that blew up their main pipelines to export crude Oil, problems in Nigeria that disrupted production from ExxonMobile, Chevron and Shell fields, all which led to a rapid ramp up of prices up to $145/b, that it would be sustained for who knows how long until they were dragged down by the (unexpected) burst of the financial markets in US and EU in the second half of the year, collapsing the economies of the biggest consumers in the world and thus, the Oil thirsty.

Over these last five years, consensus is that global economy has been doing better, financial markets have healed from their wounds and the consumption indexes are on the rise again. This has been translated as the reason for the high Oil prices that have lasted until last summer, when again, prices collapsed rapidly.

It seems that this time the main reason is the oversupply of Oil, thanks to newly production techniques -Shale Oil, to be more specific and in particular in the US- and the increase of the production all over the world, that is glutting the inventories while the demand is not growing accordingly.

What goes around comes around

If the oversupply is the reason for this roller coaster in the markets, a battle of prices is about to be waged by the NOC´s, the major Oil companies and other secondary producers, where the last standing would be the strongest and the fittest. That is why cutting capital investment for the next years sounds like a good strategy to cope with the upcoming storm, but for different reasons: NOC´s are pumping the cash to theirs governments budgets, who now must plan for lower revenues, while major Oil companies must defend theirs shareholder´s investments and guarantee some acceptable yields and as for the secondary producers, liquidity is the only factor keeping them away from bankruptcy.

For the moment, nobody knows how much this situation of not-investment can last without hurting the real Oil production and for sure the market will adjust itself, as some analysts say, but the truth is that this slash in spending will create a shock wave that will negatively impact the service companies around the Oil business, particularly in some years from now when probably the prices have stabilized and nobody remembers the news from today.

Service providers in the Oil & Gas business such as engineering companies, material/equipment suppliers and construction contractors, rely on the continuous flow of cash from Oil companies that are in need of expanding their upstream facilities, building new refineries -or revamping old ones-, distribution systems, etc. Sudden cut of investment can damage severely these service companies and some might never raise up again after the spending restarts.

Usually the lifecycle of any big project in this business is around five years, from its definition to the start-up. The first two years of definition (engineering) are less capital intensive and requires a fairly low amount of human resources, but the last three years are for executing the project and is when most of the investment is made (material procurement and construction) and when is more intensive in terms of resources involved.

Over the last years, high revenues from high oil prices encouraged Oil companies to make big project investments in upstream and downstream, and some of these projects are about to be finished during this year or the next one. Those service companies that are currently at the end curve of these projects will have to face from now an stagnation period, due to lack of investments, that can dangerously push them to the border of financial losses.

If a “project drought” is coming, we can expect more competition between engineering companies and a cloudy period for material vendors and construction contractors. If the situation persists, lay offs will come, losing experienced resources that will be necessary after the investment is resumed in the future.

When one door closes, another one opens

Due to the cyclic nature of this business, service companies have become highly efficient and might be prepared to withstand the coming storm. Lack of investment from Oil companies might have a negative impact on the service market in the following years, but on the bright side, cheap Oil prices means also more profitable refining margins and cheaper feedstock for petrochemicals.

Better refining margins will provide some additional financial cushion to those vertically integrated Oil companies and if cheaper Oil prices really boost the global economy, we will see a trend of rising consumption of goods, which is linked to the increase of the demand of petrochemical products . This should keep at least the sale price (of petrochemicals) at current levels, despite the Oil price drop.

If the Oil price sustains at relative low prices due to overproduction for the next years, and the margin between the feedstock and the sale prices of the petrochemical products is better due to this situation, we will see more petrochemical expansion projects -from revamps to grass root- which will not only can take advantage of the economics of the market, but as well the availability of numerous service companies at very competitive costs.

ChM.

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Disclaimer:

The opinions expresses herein are my own and do not necessarily represent my employer´s views in any way. Nothing posted here should be considered official or sanctioned by my employer or any other organization I am affiliated with.