Strategy Bulletin  

06/10/2015

ADAPTING TO LOWER-FOR-LONGER OIL PRICES

Pascal Menges, an energy sector specialist at Lombard Odier Investment Managers, gives his view on the outlook for oil companies, global oil demand and market dynamics.

At current low oil prices, investors have every reason to wonder whether the major oil companies can generate profits. In reality, these ‘majors’ can barely generate free cash flow and have to rely on debt to cover their dividend obligations. Some have chosen to pay dividends in shares which, de facto, corresponds to a regular capital increase. In the near term, for some of them, the brunt of the fall in the oil price has been smoothed by strong margins from oil refining activities, and trading profit thanks to the prevailing ‘contango’ in the oil price future curve (where the spot or current price is lower than the ‘forward’ price of buying oil for future delivery).

If this reverses in the last quarter of 2015, the oil majors’ weakness will be even more glaring. With lower-for-longer oil prices, their dividends are unlikely to be sustainable. Large corporations must then, we think, cut costs and defer projects even more aggressively than they have so far. Several companies, we believe, have inappropriate project portfolios with too-high breakeven costs, such as projects in oil sands, ultra-deepwater and Arctic drilling. We believe that such portfolios will likely have to be re-tooled, either through finding lower cost solutions and/or through mergers and acquisitions.

The picture from the US shale gas and oil sector is patchy. Some companies have assets in very attractive geologies; others are in less attractive areas. Many firms have leveraged corporate structures that may pose challenges with growing financial debt. In general, we would expect those companies with the best geologies and solid balance sheets to come out stronger from this downturn. We have seen massive improvements in cost and efficiencies in this sector in recent years. Contrary to long-term projects such as those in deep seawater, or oil sands, cost deflation in US shale has been as large as 30%. (Source: Citi September 2015). Some US onshore companies have also managed to rapidly drive down costs and reach cash flow neutrality. But this is very different from the oil majors, where such a rebalancing is likely to take years… if ever. We believe this means that investors should focus on more ‘short-cycle’ business models like US onshore companies. The strongest of these companies can now resist low oil prices, while keeping their ability to re-start growth quicker than others. This view also leads us to a preference for companies that provide services to those onshore players, in the form of rigs, pressure pumping, sands, pumps or chemicals.

The drop in the oil price poses multiple challenges worldwide. Unless the oil price rises above USD/60bbl, we believe US oil production will likely drop by the end of 2015 and into 2016. US conventional oil, which accounts for about half of US production, is already in decline. And declines continue in Mexico, Venezuela, Colombia and Nigeria, while Brazil has lowered its production outlook as far as 2020. Multiple projects have been delayed and/or cancelled in deepwater and oil sands.

Putting aside the volatility around the Lehman crisis in 2008, we believe 2015 is likely to be the strongest year in terms of oil demand in a decade, thanks to the boost from low prices. 2016 is also shaping up as a strong year in terms of oil demand growth. We therefore see a rebalancing of the oil market in 2016. In addition, given the fight for market share within the Organization of the Petroleum Exporting Countries (OPEC), we calculate that their spare capacities will have dropped to about 2% of global demand by the end of 2016, the lowest levels in a decade. Could US onshore players by then be flexible producers swiftly matching market requirements? This is an important question. As time passes, oil services companies’ ability to re-hire thousands of laid-off people is diminishing as they find jobs outside the sector. Equipment inventories are also being run down. We think it would take 8-12 months for US onshore players to be able to respond to any sufficiently-convincing oil price hike. Such dynamics are laying the ground for a potentially very volatile oil price environment.

Only a successful peace process in Libya and/or a major emerging markets dislocation could derail those dynamics. And we don’t think such scenarios, for now, are likely.

 

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