The free fall in global oil prices would have seemed unthinkable only a few months ago. Brent Crude was selling for around US$115 per barrel as recently as June 2014. The following graph shows the more than 45% drop in the price.
Did any of the experts covering oil see this coming?
In fact, firms like Goldman Sachs had been predicting declines as far back as July 2014, but not the collapse we’ve seen. On 28 October Goldman predicted the price of US based West Texas Intermediate (WTI) dropping to US$70 per barrel by the second quarter 2015. As of early 18 December the price of WTI stood at $54.61 and Brent Crude dropped below $60, at $59.49.
In August the International Energy Agency (IEA) cut its forecast for demand growth for oil through 2014 from a July forecast of 1.2 million barrels per day (MBD), a drop of 180,000 barrels from the prior forecast. The agency proceeded to cut its forecast three more times.
Throughout the first decade of the 21st century producers could not supply enough oil to meet the roaring demand from emerging markets, most notably the exploding Chinese economy. Economics 101 tells us too much demand chasing too little supply will drive up prices. Higher prices in turn spur production which can over time put the supply/demand equation out of balance. In short, that is what happened.
As oil prices soared, producers in the US and Canada tapped into more expensive sources of oil such as shale formations and tar sands. The media harped on about the “energy revolution” underway in the US. Some experts boasted that US oil production would surpass Saudi Arabia by 2020. Now the time frame has shortened to 2017 or 2015, depending on who you talk to. When you factor in related liquids some claim the US is already the world’s top producer.
The demand side of the equation is softening with an economic slowdown in China and deteriorating conditions in Europe and Japan. We are in fact out of balance, as seen in the following graph from an IEA report.
In defense of some of the oil experts and analysts, the anticipated production slowdowns due to geo-political concerns in Libya, Iraq, Africa, and Russia simply did not materialise. Libyan oil production actually rose beginning July 2014 and production in Iraq reached a 30-year high. The conflict in Ukraine did not impact Russian oil production. Conventional wisdom was that the stagnant or declining production in some areas would serve as somewhat of a counter-balance to the surge in US production.
In addition, as prices began to slide another tenet of conventional wisdom fell by the wayside. Collectively OPEC (Organization of Petroleum Exporting Countries) accounts for about 40% of global oil production. In the past OPEC countries have cut production to stabilise prices and many analysts expected them to do the same.
As you know, they did not, accelerating the drop in oil prices and sending global share markets into a tailspin. The move came as a surprise as these countries rely heavily on revenue from oil sales to support national budgets. While Saudi Arabia reportedly has sufficient cash reserves to survive falling prices, other OPEC countries do not, with Venezuela now in danger of defaulting on its debt obligations.
There has been speculation that Saudi Arabia in particular is willing to see the calamity continue in the belief lower prices will force the more expensive US shale oil production to falter. Whatever the reason, the question on everyone’s mind is what next? As a corollary, investors all over the world are eyeing the share price declines in energy stocks. Are we looking at value-driven investing here or does the knife have further to fall?
While some have referred to the OPEC decision to maintain production levels as the start of a “price war” one could also look at the next phase as a chess match amongst the world’s key oil producers. The action on the board will undoubtedly be on the supply side. The Chinese economic slowdown is real and is in fact part of the new government’s economic strategy. One factor in developed economies that may merit more attention is the rise of fuel efficient transportation, lowering demand for oil. Combine these two elements with some economies teetering on the brink of recession and one would be hard pressed to suggest increasing demand will stabilise and drive oil prices higher.
On the production side some analysts believe US shale production will continue to grow, but at a slower rate. Reuters recently reported drilling permits in the US dropped 40% between October and November. However, in a November report from Citi entitled Energy 2020: Out of America: The Rapid Rise of the United States as a Global Energy Superpower researchers claim the price of WTI Crude would have to fall and remain around $50 before established US shale production growth would decline. As the permitting decline indicated, new production is more at risk.
Russia has announced it has no intention of cutting production and most OPEC countries reiterated their intention to stay the course. In short, right now it appears none of the major players are ready to make a move. That could all change if Brent Crude, already below $60, keeps falling. The Russian economy is in a sorry state and it is doubtful they could withstand lower prices for an extended period. Even the cash-rich Saudis will feel the pinch. At $60 dollars a barrel the Saudis will be running a budget deficit in 2015 approaching 14% of the country’s GDP.
Watch the price to see who blinks first. In the meantime, does it make sense to invest in any of our own oil and gas producers? Here is how the share price of our biggest player Woodside Petroleum (WPL) has performed over the last six months.
Woodside has the benefit of its substantial LNG (Liquefied Natural Gas) presence and has a fully franked current dividend yield of 6.38%. As you can see from the chart, despite the continued fall in the price of Brent, WPL stock has gone up a bit. However, global markets at the moment appear to be ignoring oil in favor of the positive news from the US Federal Reserve regarding the country’s economic outlook and a commitment to be “patient” in its timing of raising interest rates.
Woodside is not the only O & G stock to consider. The following table includes three others that could be worth a look.
52 Week % Change
6 Month % Change
Book Value per Share
2 Year Earnings Growth Forecast
Woodside Petroleum (WPL)
Oil Search Ltd
All of these stocks have significant interest in LNG production. Origin Energy (ORG) has the added benefit of exposure to electricity generation and distribution. But the falling oil prices are casting a shadow over the potential of our LNG exports as most Australian LNG contract pricing is linked to the price of oil. A UBS analyst in Melbourne claims Australian projects need an oil price at $US75 to $US90 a barrel to yield a 10% return. Hence, should the price of Brent Crude remain low for an extended period or even go lower, the math does not favor our LNG producers.
While the growth forecasts for Origin and Oil Search (OSH) appear attractive, remember those estimates may be based on oil prices no longer in play. While the LNG revenues for projects about to go online generally reflect long-term contracts based on a higher oil price, a continuation of the falling trend in oil pricing will not be good for expansion plans nor for the long term future.