Investors have been panicking by the drop in oil prices as of recently. Why panic if you know with certainty that oil prices will rise again within a year or two's time? Well the majority of overleveraged junior and medium sized oil and gas development companies should panic a little, but I think that this drop in prices is going to be a major opportunity for some larger oil companies. Investors need to hang on to their quality companies because in the long term, higher prices must eventually prevail.
Why prices must eventually rise
There seems to be some insecure fear that most people have where the whole oil and shale industry is going to collapse. I think this is a bit unreasonable if you look at the big picture. The oil industry landscape is made up of a few different types of players. It is important to differentiate between the players because their ability to play the oil game is different. The first set of players are the sovereign players which include OPEC, Russia and a host of countries who are dependent upon oil for the survival of their economy, government budget, etc. These countries control a large portion of the production and they can certainly affect prices if they act together as we've seen lately. The second set of players I would generally call the capitalist players and they consist of oil companies that operate in the U.S. and Europe under market capitalist regimes and rules. Yes they may have to interact with other regimes, but for the most part, they are pure corporations. Let's compare these two groups.
Sovereign versus capitalist
The sovereign players are relatively very dependent on the price of oil due to the social contract between those who control the oil production and those who live under the rule of these regimes. The government's responsibility is ultimately towards the people of their respective countries. Government revenues provide for social services and infrastructure while the direct and ancillary effects of the oil businesses drive all the other kinds of businesses. Some countries are richer and can take the pain of lower prices longer than poorer countries. However, their geography connects them so deeply that they are unable to act completely alone when situations go to the extremes. Contrast this with the capitalist system we have in the U.S. The social contract between an employer corporation and their employees are far different than the relationship between government and the people. A fired employee can simply move on to a different job and if his skills are not transferrable, he may simply learn new skills to find another type of a job. On the other hand, the people of a nation are stuck with the government's decisions and have no choice but to continue living under the same institution. If they have a problem with their regimes or living condition, they cannot leave or be fired. The government is completely responsible for them since they will either prosper or suffer under the government's direct decisions. This means that the capitalist system is much more flexible whereas the sovereign system is rigid. Overleveraged companies may go bankrupt and other corporations may decide to halt production. The capitalist system is always finding methods to becoming more efficient in controlling their costs. The governments cannot afford to go bankrupt or halt production. They must continue dancing even after the music has stopped.
Well-capitalized versus overleveraged
A further two distinct groups of players in the oil game can be found in the capitalist system. The first group would be called the cowboys. They include certain medium sized and junior oil companies who are leveraged up in a bid to get rich quickly while prices allow them to be extremely profitable. In a prolonged downturn in oil prices, they're likely to go bankrupt. They put themselves in a situation where if they stopped pumping oil, they would not be able to sustain their debt load for a long period of time and would pump until they cannot go on. These companies may best be avoided in a prolonged downturn. The other group consists of the medium to large (although there are a few small ones) oil companies that are well capitalized and can resist low prices for an extended period of time, much longer than any sovereign oil dependent country can afford to take. These companies include the likes of BP plc (NYSE:BP), Chevron Corporation (NYSE:CVX), ExxonMobil Corporation (NYSE:XOM), Royal Dutch Shell plc (NYSE:RDS.A) (NYSE:RDS.B), Total SA (NYSE:TOT), and ConocoPhillips Company (NYSE:COP) to name a few of the big names. Although most people see oil prices as a weakness, it is actually an opportunity for really well capitalized companies to cheaply acquire others under the cost of exploration and building it themselves.
The best capital allocator
The final distinction I want to make is within the group of well-capitalized oil companies. There are certain companies within this group that absolutely excel in the capital allocation process. They excel by being contrarians in the way they act. They always keep enormous cash reserves and never leverage up even when times are good. When times are poor, they refuse to pump oil from unprofitable assets and instead go looking to acquire cheap assets when others must sell them or cannot afford them. They have cash when cash is most needed. I believe ExxonMobil is such a company. It is the most distinguished company in the group in terms of their capital allocation track record and will probably come out of any crisis the strongest. Such a downturn is an opportunity for profit for such a company, not loss.
Disclosure: The author is long BP, XOM.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.