The Missing Link Between Oil Price & O&G Profitability

Oil price has moved higher to almost US$50 per barrel recently. Yet, there is a continuous stream of bad news from Oil & Gas (O&G) companies. We had Linc Energy going to voluntary administration in Apr, Ezra reporting quarterly losses of US$283 million at the same time and Technics Oil & Gas going into judicial management recently. Is the disparity between oil price recovery and bad news from O&G companies just a lagging effect or are there some other factors unaccounted for? If it is solely a lagging effect, the gradual improvement in oil price in recent months should progressively lead to better business conditions for O&G companies and the current wave of bad news could potentially mean the worst of the slump is near. However, if it is some other factors at work, the wave of bad news might not end so quickly and the prices of O&G stocks might continue to slide. Just a disclaimer before we continue: I do not work in the O&G industry. Like many investors, I have invested and lost money in O&G stocks. The information in this post is based on information that I gathered in my attempt to recover the losses in my O&G stocks. Hence, any incorrect information is unintentional and regrettable. Do not rely on this post for your investment decisions.

The answer to the question above is both. Let us tackle the more fundamental question first. Although the fortunes of O&G companies are tied to oil price, the relationship is not a direct one for most companies. Only companies that are involved in oil exploration and production (E&P) such as Kris Energy and Interra Resources have a direct relationship with oil price. These E&P companies produce and sell oil in the market. Any change in oil price has a direct impact on their profitability. The majority of the O&G companies listed on Singapore Exchange, however, do not produce oil. Instead, they supply equipment and services such as Offshore Support Vessels (OSVs) to the E&P companies. These OSV companies include the likes of Ezra, CH Offshore, etc. Then, there are shipyards that build equipment for the OSV companies such as Keppel Corp, SembMar, Triyards, etc.

Thus, from the relationships above, the fortunes of shipyards are dependent on the OSV companies, which in turn are dependent on the E&P companies, which then in turn are dependent on the oil price. I reproduce this diagram from Marina Money Offshore to illustrate the O&G industry supply chain.

O&G Industry Supply Chain

Thus, to understand the fortunes of OSV companies and shipyards, it is not only necessary to know the trend of oil price, but also the spending budgets of E&P companies. Oil price has been discussed previously in The Demand and Supply for Oil and Understanding Saudi Arabia's Game Plan on Oil Price. This post moves the discussion downstream to the E&P sector which has a greater influence on the profitability of OSV companies and shipyards than oil price.

Although there are small independent producers like Kris Energy and Interra Resources, the E&P sector is dominated by National Oil Companies (NOCs) such as Saudi Aramco and Petronas and Intenational Oil Companies (IOCs) such as Exxon Mobil, Royal Dutch Shell, BP, etc. As mentioned earlier, oil price directly affects the profitability of E&P companies. In their attempt to navigate the deep and prolonged slump in oil price since Jun 2014, they have cut E&P spending budgets, jobs and deferred major projects. Such spending cuts are likely to continue (see Oil Spending Seen Down $70 Billion Next Year (i.e. 2016)), even though oil majors have reported better than expected earnings in 1Q2016 due to their downstream operations (see Oil's Profit Surprise Has Analysts Wondering How Well Exxon Did). 

In my opinion, even if oil price were to recover to higher levels, oil majors will be very cautious in raising spending budgets to previous levels after going through such a difficult period. As discussed in Understanding Saudi Arabia's Game Plan on Oil Price, there are structural changes to oil price. With OPEC producing to their full capacity regardless of price, oil price is likely to become more volatile and oil majors are likely to become more conservative in their capital expenditure. All these mean that while some business will return, the good old roaring business is not going to return for some of the OSV companies and shipyards.

I mentioned earlier that there is a lagging effect between oil price and profitability of OSV companies and shipyards. Based on the industry supply chain discussed earlier, there is indeed a lagging effect between higher oil price and improved profitability of O&G companies. However, from the discussion in the previous paragraphs, it is likely to take a fairly long time before we see higher profitability for O&G companies. In the meanwhile, it is still downhill based on E&P spending budgets and you can expect to see more bad news from the 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.

See related blog posts:

• The Demand and Supply for Oil
• Understanding Saudi Arabia's Game Plan on Oil Price
• What Moving Averages Can Teach Us About O&G Stocks