Why Cheap Oil is Great for the Majors

For the last 3 years, the world’s oil majors have not had an easy time from the oil producing states. Increasing oil prices has led to a complacent attitude by oil reliant governments. This often masks inefficiency, sometimes corruption, and has led to high taxation coupled with unsound business practices. Russia's oil production for instance, has been reducing each year despite the governments desire to increase output. Easy credit and a speculative environment resulted in many new oil companies coming to the market, with high valuations and little, if any, proven reserves. As the oil price increased so did the tax receipts and so did the smaller companies share prices. This resulted in state influenced companies investing less and the global situation where finding new oil, or purchasing oil reserves, became ever more expensive due to the barrel price and the demand for people and equipment.

Times change, oil is now trading around $65 per barrel, a 16 month low, but still way above its 2002 price of $25. Prior to this it has not been higher than $30 since 1987. Was $25 artificially low? Have China, India and Russia really started using so much more oil in the last six years that oil should be substantially more than $25?

Who knows, but from a long term investment, the price can be ignored. The share price of the large oil companies does not fluctuate with the price of oil, and nor should it. Long term contracts and many different aspects to the business means the month-by-month barrel price makes little difference to revenues and earnings. A world recession will make a difference but the long-term case for building an investment over the next 12 months is compelling.

The current price of oil is very bad news for many of the OPEC countries, whose governments, or ruling factions, often manage to exist through maintaining social programs funded by oil receipts. Russia less so, but it’s hugely dependent on oil revenues and the health of the oil industry. These countries have followed the rest of the western world and spent while the going was good, but now it's a different story. Consider that to balance the books, Russia needs oil above $70, Iran and Venezuela need $80 and a similar figure for all the rest.

So what are the likely actions of oil producing countries, state influenced companies and the impact to the majors?

If we assume that the oil price continues to fall, or not recover, and that demand falls or production is cut, then none of this is good news for the oil states. In a slowing world economy it is likely that all three will occur. Apart from making life very difficult for the leaders of the countries dependent on oil, it is likely to result in less investment in the industry. When the economic cycle turns, as it will, they will turn to the majors to bring in expertise and assistance to increasing output and efficiency with a need to enter new or enhanced joint ventures. They will also be more open to providing access to possible reserves that they do not have the skill or experience to develop.

The majors will negotiate hard in any venture or partnership remembering the treatment received during the last few years, the obvious example being the tactics and problems encountered with the TNK-BP venture. For their own future planning, the majors use a long-term investment assumption of $ 30 - $40 per barrel, so any investments in their own business should not be too badly impacted by the lower barrel price. In addition the planned investments will not be competing for the physical and human resources that have been so scarce for the last few years.

This situation cannot be said, however, for the many small oil producers and explorers whose share prices are almost totally dependent on the prevailing oil price. Large oil companies are well funded and have access to credit, which many of these smaller companies do not, and this makes them highly vulnerable to being taken over at depressed prices by the majors, thus acquiring long term reserves at sensible prices. There is certainly no shortage of small companies, which have been funded by other people’s money, that now look attractive targets.

In the medium to long term, we are looking at a relatively healthy and well prepared commercial industry, with the state influenced sector under invested and in a weaker position. This might not be good for the economy as again it indicates supply and demand imbalances, but the oil major’s plan for volatile oil prices, they always have done and always will do.

So the fall in demand will impact the large oil companies, but this is a short term impact and many of these firms have been around for a long time and are used to planning for economic cycles. The cycle is key to the reason why these companies now make a compelling case for investment. If we assume that within 3 -5 years the world economy starts to grow again, and continues its upward path of growth, which it always has done, the long term benefits of cheaper reserves and under investment by others will be good for the future of the independent oil companies.

With good yields, strong balance sheets and a long term growing market, it gives a strong argument for investing into the likes of Exxon (XOM), Chevron (CVX), BP (BP) and Shell (RDS.A) over the next twelve months as a traditional buy and hold stock.

Disclosure: Author holds long positions in BP and RDS.A

Comments

[john s. gordon:]

the russian & iranian military buildups depend on maintaining high $/bbl in world markets.
> jack

2008 Oct 26 09:28 AM

[NOWHEREMAN:]

In a world running out of Cheap oil, cheap oil only means the next rise will be from a higher base, and there will be less cheap or expensive oil available, since many expensive projects are either being delayed or aborted all together.

2008 Oct 26 10:36 AM

[satch63:]

Your understanding of BP-TNK issue shows how little you understand about the issue.
If you were assigned by BP your bonus and living package was soi in excess of other TNK employees it became an issue.
The out going President was so pro BP anti TNKBP it is no question he was causing the company problems.

2008 Oct 26 10:36 AM

[Namdogon:]

You say "If we assume that within 3 -5 years the world economy starts to grow again, and continues its upward path of growth, which it always has done"

As economic 'growth' is built on an expanding energy base and we are close to or have reached the point of maximum energy extraction in the world i.e overall energy available will decline, this is a very big assumption to make. Ok things might get better for a while in 3-5 years but this will only be short term on the roller-coaster of long term energy decent/economic depression.

(Liquid crude oil production is close to peak, coal & gas will follow in 10-15 years, uranium in 20-25 years - investment in renewables is totally inadequate considering the energy gap crisis we are heading towards)

Our economic system will have to change from one based on ever expanding debt to one based on real resources - energy being best candidate.

2008 Oct 27 03:15 AM

[CLH:]

Namdogon---Growth will always be based on money but less will be debt for some years. Less and less energy will be needed for growth in the future.

2008 Oct 27 09:58 AM

[John Henry:]

Satch, I am sure there are good reasons why the BP-TNK relationship broke down but the example was to highlight the approach that is often taken against the large oil companies when high oil prices prevail. Other examples include Venezuela nationalising its oil industry, Bolivia nationalised it's gas industry.

It is natural to maximise your position when in a position of strength, for the last few years the majors have not been in that position but that will change and when it does they will look to negotiate strongly in their favour.

That may just be the start of the cycle again but non the less, a strong negotiating position should be positive for earnings.

2008 Oct 29 06:17 AM

[tezza6633:]

I'd agree with the fact that oil is running out and owning a company that owns oil looks good to me.

2008 Oct 30 08:50 AM