Is the decline of oil price since Jun 2014 a cyclical decline or a structural change? This question has important implications, as it affects whether Oil & Gas (O&G) stocks, which have been severely beaten down, are bargains. If it is a cyclical decline, it is only a matter of time before oil price recovers to higher levels and good business returns to the O&G companies. However, if it is a structural change, the good old business might never come back to some of the O&G companies again. To understand whether oil price is in a cyclical or structural decline, it is important to understand the intentions of the largest oil producer -- Saudi Arabia, whose actions affect oil price and the fortunes of the O&G industry to a great extent. Please note that I am not an expert in O&G and this post is very much a speculation on Saudi Arabia's game plan on oil price.
For a long period of time prior to the oil crash in Jun 2014, Saudi Arabia and OPEC had been moderating oil price, increasing production when oil price was favourable and cutting back when oil price was declining. This worked well, so long as other oil producers could not take advantage of OPEC's cutback and increase their own production. Things changed with the shale oil revolution in the US, which increased US' oil production to 9.2 million barrels per day (mb/d) as at Mar 2016, nearly matching Saudi Arabia's production of 10.2 mb/d (source: Oil Market Report). The more OPEC cuts back on production, the more its rivals will step in to take market share from OPEC. In the long run, this is not sustainable as OPEC will steadily lose market share to other producers. Thus, in Nov 2014, Saudi Arabia and OPEC made an important decision not to cut production any more to support oil price. Oil price fell precipitously as a result. After 2 years of oil price decline, the lower oil price has started to take a toll on US shale production, reducing production by 0.6 mb/d from the peak of 5.5 mb/d in Mar 2015.
The price war is not without cost to Saudi Arabia and other OPEC members. Fig. 1 below, extracted from a World Bank research note in Mar 2015, shows that OPEC producers derive a great proportion of revenue from oil production.
|Fig. 1: Percentage of Total Revenue from Commodities|
Fig. 2 below, from the same research note, shows that the fiscal break-even price of oil, i.e. the price at which government revenue evenly balances expenditure, can be as high as USD100 per barrel for many OPEC producers.
|Fig. 2: Fiscal Break-even Price for Oil|
At the current oil price of USD45, many OPEC producers have difficulties financing their public expenditure and need to dip into their past reserves. Thus, although it is in Saudi Arabia's long-term interests to sustain the price war and reduce competition, there are short-term transitional pains to be addressed. Hence, it is no surprise that Saudi Arabia and Russia agreed to conditionally freeze production in Feb 2016 and to discuss production freeezes with all major oil producers in Doha in Apr 2016. Although the Doha talks failed to reach an agreement, the impact is manageable as the world demand and supply for oil is projected to almost reach equilibrium in the second half of 2016 anyway (source: Oil Market Report).
To improve its ability to sustain a prolonged war price and protect its market share in the future, Saudi Arabia has made long-term plans to reduce its reliance on oil revenue and lock-in market share. The proposed listing of Saudi Aramco (Saudi Arabia's state oil company) is a step in diversifying its economy from oil exports (see Saudi Arabia Plans $2 Trillion Megafund for Post-Oil Era). Another key step to lock-in market share is its expansion of refining capacity. Already, Saudi Aramco has equity stakes in oil refineries worldwide with a refining capacity of 5.4 mb/d. These refineries provide a ready buyer for its crude oil. It plans to increase this to 8-10 mb/d (see Saudi Arabia rewrites its oil game with refining might). At 10 mb/d, it is nearly equal to Saudi Arabia's current oil production of 10.2 mb/d. When that happens, it no longer needs to fight for market share with other oil producers.
Coming back to the original question of whether oil price is in a cyclical decline or structural change. The answer is both. It is cyclical in the sense that it is only a matter of time before oil price recovers to higher levels, as projected by the Oil Market Report. Last week's post on The Demand and Supply for Oil also shows that the demand and supply for oil are both inelastic above a certain price. When both are inelastic, higher price is possible.
However, there is an important structural change to the cyclical nature of oil price in future: Saudi Arabia will maximise production regardless of the level of oil price and will not cut production to support oil price. It is akin to stepping full force on the accelerator pedal regardless of whether the car is going uphill or downhill. The net effect is oil price will become more volatile than in the past when Saudi Arabia and OPEC moderated oil price.
Although oil price changes are partly cyclical and partly structural, the effect on O&G companies is more structural. Firstly, when Saudi Arabia and other OPEC members produce to their full capacity, all other higher-cost producers will be left to fight for the remaining share of the oil market, profiting when oil price is high enough and making losses when oil price is low. O&G companies that provides equipment and services to the higher-cost producers will be similarly affected. Secondly, when oil price is volatile, companies will become more conservative in making investment decisions. Imagine that you are an executive deciding whether to place an order for an oil rig that costs USD 800 million and is delivered only 4 years later. You do not know whether the oil price then is going to be USD30 or USD80. How do you make that investment decision? Some business will return, but the good old roaring business is not going to return for some of the O&G companies. This is why I mentioned in my previous post there are important differences between oil price and the economics of O&G companies.
Just a reminder, I am no expert in O&G. I am only an investor trying to work my way out of the O&G mess in my portfolio. It is a battle that I have no confidence of winning.