The Biggest Winners And Losers From The Immediate Oil Market

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Includes: AAL, CVX, TSLA
by: Integer Investments

Summary

In response to electric vehicles, oil companies are likely to increase supply

This will push down oil prices and slow electric vehicle growth

Despite this, total increase in automobile demand will mean oil demand increases over the immediate term.

We analyze the impact of oil dynamics on Chevron and American Airlines.

Introduction

The world underwent a revolution upon the creation of the first internal combustion energy over a century ago. Since that time, combustion engines powered by petrol and diesel have completely dominated the economy. Electric transport solutions have existed for virtually the entire time that combustion solutions have, yet they have been held back by a number of key technological limitations that prevent widespread uptake. Chief among these battery technology, which until recently made it impossible to use electric vehicles over any kind of useful range. While petrol or diesel vehicles may be filled up in a number of seconds and travel for huge distances on a single tank, electric vehicles have not shared the same advantage. Traditionally they have had batteries which featured extremely limited range and can take hours to fully charge, making their usefulness pale in comparison to that of their historical competitor for consumer uses.

The General Motors EV1, an early electric vehicle concept:

Now we see concerted trends indicating that electric vehicles will come to fully displace traditional vehicles with internal combustion engines in the next three or four decades. This has major implications for any number of different industries, with oil being the most affected. This article examines how the oil industry will respond to the new revolution, and attempts to provide some insight into the timeframes in which all these changes will take place.

This article further analyses the effects of future price trends on two companies in particular, who stand to be affected the most by the changes: Chevron (CVX) and American Airlines Group (AAL). Chevron, which was spun out of Standard Oil, is a multinational firm operating along every point in the global energy supply chain, from speculation and extraction through to refinery and sales. The company has made several big capital investment bets on the oil market remaining fairly strong in the future, and will be well placed to benefit from higher than expected oil prices. American Airlines, on the other hand, is a highly indebted legacy airline still struggling to improve its finances. It will be among the least able to absorb higher fuel costs and may be one of the biggest losers from a sustained period of high oil prices.

Analysis

Battery technology is overwhelmingly important to this topic. Consumer experience is significantly impacted if they have to stop for over an hour while waiting for their vehicle to recharge on the road. Even the supercharger network laid out by electric vehicle firm Tesla (TSLA), which allow for users to recharge their vehicles away from home, take over an hour to charge up to full capacity. Progress has been fairly slow in this area, and more investment will be required before we see changes in consumer preferences.

A Tesla supercharging station:

The functioning of electric vehicles at a base level is also fundamentally different to that of combustion engines, with important implications for production. Rather than making use of a pressurised piston system, EVs employ an electromagnetic drivetrain to rotate wheels, removing the need for transmission and some converters. The much smaller number of moving parts means that the vehicles are simpler to put together and break down far less often over the course of their useful life. They also accelerate extremely rapidly. Energy conservation is also enhanced through an important feature whereby electric vehicles can recapture kinetic energy when they brake and store in back in the battery. This is energy that would simply be wasted in a traditional engine upon braking where momentum is lost.

The use of lithium-ion batteries, which have seen massive advances in terms of charging speed and capacity have meant that the ranges seen for EVs have been revolutionised. Standard ranges are now in the hundreds of kilometres, with several vehicles currently on the market operating between 300-400 km on a single charge. The cost of producing these batteries has also come down quickly, through both improvements in technology and the scaling of production facilities. For example, Tesla’s Gigafactory 1 is expected to produce as much battery capacity as the rest of the world combined when it is at full operation. The cost to produce a kilowatt hour has fallen from over $1,000 at the start of the decade nearly tenfold to almost $100 today. Government policy will also play some role in the increasing uptake of this new technology. Many countries already have significant incentives in place for vehicles with lower emissions, and several European countries have pledged to outlaw sales of petrol and diesel vehicles by 2050.

A mockup for Tesla’s lithium-ion battery factory Gigafactory 1, currently under construction in Nevada:

The importance of this trend cannot be overstated, with over 1 billion cars on the road worldwide and huge uses in both industrial and domestic applications. Electric vehicles promise the need for fewer specialist engineers and servicing providers as they are mechanically simpler and are mostly maintained through over-the-air software updates. A huge amount of electric vehicle production is automated, and large amounts of the engineering and design work is done by professionals from outside the traditional auto industry.

Most important, however, is the effect this will have on the most crucial complementary good to combustion cars: Oil. Two thirds of oil consumption in the United States is through vehicle use. Industry expectations about oil price collapses are likely to lead to increases in supply to full potential over the coming years, as companies make sure their existing reserves are not squandered when demand for oil vanishes. OPEC will find it all but impossible to maintain supply restrictions; they have already found such difficulties keeping countries in line with the emergence of important exporters like America through their shale gas boom.

This creates a feedback loop, whereby uptake in electric vehicles also slows as the price differential narrows slower due to decreased petrol costs making combustion vehicles more appealing. These factors should thus maintain an equilibrium which sees slightly slower disruption and slightly higher oil prices than would be expected with rapid industry change. Over the long term, however, the internal combustion engine is likely to only maintain dominance in industrial logistics and freight applications, such as shipping and aviation for the transport of goods.

Electric drivetrains have few moving parts, unlike internal combustion engines:

In a large number of countries, the current number of plug-in sales is low; only around 1% of new vehicle sales for many parts of the developed world. However, most analysts’ predictions expect this figure to skyrocket and hit close to 80% in only about two decades’ time.

Big multinational oil companies, in recognition of this trend, have been massively diversifying their portfolios by investing in wind and solar technologies, as well as natural gas, which is projected to see sustained increases in demand over the coming years. Hydrogen as a transport fuel is also an important investment avenue for companies like Royal Dutch Shell. Automakers are also getting a slice of the new action by placing large bets on the electric vehicle revolution, both internally and externally. Volkswagen wants to see at least 25 percent of its vehicles sold in 2025 to be EVs. Toyota is moving toward selling zero fossil-fuel powered vehicles by 2050. Many large automakers rank among the most significant investors in electric vehicle startups like Tesla.

Another major trend towards lower oil demand is improved efficiencies within combustion engines. In fact, many argue that the impact of this is much more important than the impact of electric vehicle disruption over the immediate term. The effect of electric car market share, at least over the next few decades, is several times smaller than that of existing cars getting more efficient. This makes a lot of sense intuitively: Even if EVs start to make up a larger and larger share of new vehicle sales, the vast majority of sales will still be powered by oil for a while yet. In this time, small advances in engine efficiency can have massive ripple effects out onto the total global consumption of oil. By some estimates, an increase in electric cars on the road of 100 million units reduces oil demand growth by 1.2 million barrels per day. Vehicle efficiency is expected to have an effect ten times as large.

BP’s Chief Economist Spencer Dale argues that the overall effect of increased demand for travel by automobile fed by growing middle classes around the world will be a much greater effect than that of both improved fuel efficiency and electric vehicle disruption, such that demand for oil will continue to increase. The main reason, therefore, for low prices in current oil markets and futures is markets is to do with the supply side.

Market Analysis

Given this outlook in terms of oil prices, several key stocks around the world will be impacted by these trends, both positively and negatively. We look at two key equities that stand to be affected:

Chevron (CVX)

Chevron is a multinational giant operating in the energy industry. If demand for oil continues to grow globally as BP believes, this company will be one of the first to benefit. That is because it has made some of the most substantial bets on expanding its capacity to produce. Huge amounts of capital expenditure have been poured into exploration and development of new oil sites at a time when global oil markets have been reasonable volatile and unpredictable. By the end of the second quarter, the company had a net debt ratio of 20.7% and successfully turned a loss into a net profit year-on-year. In addition, their net cash flow from operations has nearly doubled from the previous year.

It looks set to continue to grow its production, when other companies have been cautious about large capital-heavy projects in a time of low oil prices. The company reported 10% Q2 growth in its supply of oil and gas due to production in the U.S, Australia and parts of Africa. Several key projects are still in the works, including infrastructure in Nova Scotia and further development in Australia.

Investors must decide where they believe oil prices will head. Over the much longer term, they are almost certain to fall significantly. Over the coming decade or so, however, the fundamentals of growing global demand indicate that no price collapse is imminent. A stable or growing oil price will benefit companies that have made the biggest moves to capitalise on such an environment. Chevron is a lead among this group of firms.

American Airlines Group (AAL)

Investors have traditionally accepted that the airline industry carries with it a fairly high degree of volatility and risk. After all, this is a capital intensive industry where a reasonable degree of risk will always be inherent. For that reason, they have been able to forgive the financial worries of firms like American Airlines Group, as airlines also have the potential to generate significant returns during the good times.

However, airlines remain some of the firms that are hit the hardest by rising oil prices. American Airlines Group is in a precarious position and will be one of the least able to absorb these losses. Investors may accept risk, but the higher that oil prices go the more likely that such risks will fail to pay off. In a situation of high oil prices, the losses for a firm like AAL will be significant.

This is mainly due to the company’s significant debt. The firm’s debt has risen even during a sustained period in which virtually all other major carriers have been reducing their debt positions. A lot of this is due to expenditure necessary to complete integration of their merger with US Airways. Their total debt has growth from just over $20 billion at the end of 2015 to close to $25 billion now.

Due to this position, this firm will be among the first in the industry to face pressure in the event that oil prices grow over the immediate term. This is mainly as a function of their reliance on low prices to drive ticket sales and keep costs down. However, high oil prices also affect their ability to service debt. A period of high oil prices will generate cost-push inflation in many economies, prompting central banks to raise interest rates in order to counter this effect. The result is that AAL’s debt becomes more expensive to service and continues to eat away at their ability to generate positive cash flows.

Conclusion

Decades from now, electrification will be an important part of the factors influencing global oil prices. It remains true that, eventually, this disruptive technology will lead to massive changes in demand for oil and other auto-related industries. Total demand, however, is not projected to drop in the near future. The uptake is too slow and the effect of emerging economies far too big for us to expect oil price collapses in the next few decades. In trying to determine what will happen to the oil market, it is far more important to look at trends in international supply.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.