Understanding The Implications Of Lower Oil Prices

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Adam Aloisi

For the average American, oil under $50 a barrel represents a tax cut. For those with lengthy commutes or typically rack up high miles on the open road, it has become considerably less painful to fill up at the gas station. This represents more disposable income that can be distributed in other places, saved in the bank, or invested in the securities markets.

That's the good news. The bad news for energy investors and employees of energy-related enterprises is that the $70 drop in oil over the past six months will mean less profits for big oil and potentially losses for niche or less-well-capitalized entities. It will also have a domino effect on those that do business with oil companies. Investors long oil are losing a lot of money and some of those affiliated with the oil space are likely to lose their jobs.

If you look at the chart above, you'll see that basically for the past four years, oil has traded in quite a narrow range, generally at a price between $100-$110 a barrel. Companies have geared their businesses, operations, and headcount towards this stable, robust pricing. This sudden, unpredicted cratering has caught most off guard, which will mean a re-tooling process for even the most fiscally sound of companies.

The impact is widespread and will affect the business of upstream, midstream, and downstream oil entities. The following is a primer on what those terms mean:

  • Upstream: Companies that deal with the exploration and extraction of raw energy assets from the earth. Drillers, submersible platform operators, for example.
  • Midstream: Companies that move and/or store raw energy assets. Pipeline builders and operators - many of which operate as master limited partnerships (MLPs) would be prime examples.
  • Downstream: Companies that refine raw petroleum into useable end-product or deliver/retail end product to consumers.

An apparent global glut of crude oil and simultaneous speculator abandonment of the asset appears majorly responsible for the drop in price. OPEC - a 12 member consortium of petroleum exporting nations has exacerbated the situation by repeatedly announcing that it would not curb its oil output.

While few remember the brief instance, crude traded in the upper teens per barrel for a brief period in the late 90s. The profit crunch back then led to a slew of mega-mergers between some of today's biggest domestic oil titans. Exxon, then a stand alone company, merged with Mobil; Chevron and Texaco also merged, so did Conoco and Phillips a few years later.

Today, the speculation is hot and heavy as to how low the price of oil may go. There are a lot of factors that will determine whether we are near a bottom or not. Future supply from OPEC and elsewhere, end demand from around the globe, activities of energy speculators, as well as regional geopolitical situations will all factor into the mix. We are conceivably only one unforeseen event or message from OPEC away from seeing the bottom. Yet with continued resonance regarding oversupply, there seems little to protect against the seemingly falling knife.

The ferocity of the decline in price is what has created the shell shock in energy markets. If the decline occurred over a matter of years, not months, it may have been easier for companies to digest. Just like the "taper tantrum" move in interest rates back in 2013, it is very difficult for enterprises to adjust to rapid-fire, unexpected events - with severe near-term financial impact as a result.

At the end of the day, while the positive benefit to consumers and negative effect on the greater energy space may make this a virtual wash to the macroeconomy, at least for the near-term it is creating a lot of havoc in financial markets.