Oil prices and related stocks

If you have been reading and following the oil trends back in the seventies, you would probably have come across some futuristic books such as from Alvin Toffler mentioning that fossil fuel is likely to be depleted in 50 years’ time from then. Using that as the beginning of the real time line, it means that ‘that future’ is not too far away, perhaps within a matter of 10-15 years from now. So, based on the ever-increasing demand especially with recent developments of China, a super consumer of oil, and with the depleting oil supply, we should expect oil prices to reach sky-high. Perhaps by now, it should be at least US$300 per barrel and beyond. Unfortunately, or maybe fortunately depending on each individual’s point of view,  the real situation right now is that the oil price is just barely above $40.  In fact, there were reports of global glut and it may be that the oil price could fall below $40 per barrel once again. Mapping out the change in the price of oil from the seventies till today, I doubt it is even able to catch up with the inflation rate.

What has led to this situation? First of all, there are huge advancements in harnessing alternative energies such as solar, wind, tidal, geo-thermal and even agricultural palm oil just to name a few. The developments in harnessing the respective alternative energies have made the world become less dependent on fossil fuel. Even within the segment on fossil fuel, there were also huge leaps in oil discoveries. In the nineties were significant advances in oil rig developments. This has enabled us to tap oil from the deep-sea beds. More recently, huge developments in shale oil exploration came to the forefront. Frankly speaking, shale oil exploration is not a new technology. It has been known in the 80s, but the environmental effect and cost of tapping shale oil have prohibited its developments until very recently when the oil price shot above $80 per barrel for a historically long time.

So, what is my point here? The developments in the area of oil exploration and discoveries have made oil price extremely low. In fact, even huge oil consumer such as United States, who had been a net importer in the 70s and 80s, has become a net oil exporter recently due to huge developments in shale oil. The OPEC, a powerful organisation more than thirty years ago, has become quite powerless in controlling the oil price. To cut the story short, the situation is that each time when the oil price reaches a certain level, new discoveries and extraction methods would help to bring the oil price down.

To help readers better understand the oil situation in a nutshell, I have tabled out the following information. (Also see picture in this link which summarised the oil price scenario.) That, hopefully, helps for people who are interested in this industry, in particular the oil-rigs related companies.

  1. If the oil price falls below $40, countries with land-based oil fields can still make money. It means that countries like Saudi Arabia, Kuwait, UAE, Venezuela, Iraq, Iran, and Algeria will continue to produce because their cost of production is far below $20 per barrel. However, companies (or countries) related to shale oil and offshore rigs are unable to produce oil profitably.
  2. If oil price falls in the price range of $40-$60 per barrel. Some efficient oil shale companies may be able to start production. Even though they may be marginally profitable or even operating at a loss, they are still able to cover part of the developmental costs. In this price range, oil rigs and offshore-related companies are still unable to start production as it is still not profitable for them.
  3. If oil price falls in the price range of $60-$80 per barrel. Some efficient offshore rigs may be able to start producing, perhaps in the North Sea or seas off Brazil and Mexico. This will also be the price range which shale oil industry will be able to produce comfortably with reasonably good profit. Consequently, shale oil companies may elbow out some less efficient offshore oil companies.  At this price range, not every company that are involved in offshore oil production can be profitable.
  4. If oil price holds above $80 – generally all production segments should be economically viable to start production. Oil rigs companies should generally be profitable. At this price range, there are sufficient oil rig orders to keep oil-rig companies as well as the peripheral companies that support the oil rig companies to be very busy. We should expect huge orders for oil rigs and these works order can keep these companies above water for several years down the road. Of course, under this situation, land-based oil companies will be laughing all their way to the bank as the profit is several folds above the production costs.

Notice also that many of the oil-rigs and the peripheral companies had blossomed in the past few years. It was because the oil price had been stubbornly high for a historical long stretch of time. For about 7 years between March 2007 and December 2014, it had consistently stayed above $80 per barrel except for a brief period during the global financial crisis in 2008/2009. At this juncture, it is also important to mention another critical condition that has to come to existence for oil rigs related companies to be in business. Not only must the oil price stay about $80, it must also be sustainable for a sufficiently long stretch of time. Let’s say if the oil were to increase suddenly to above $80 per barrel for 2 months and drop back to $40, it is unlikely to pent up the demand for oil rigs. Oil developments and exploration are heavy engineering projects. Each project needs at least 2 years to develop from the initiation stage to the final delivery. (In fact, I would think even 2 years is extremely optimistic. Three to four years are probably more realistic figures.)  So, it means that in order for the demand for oil rigs to be hot again, the oil price has to stay consistently above $80 per barrel for at least 2 years. It so happened that between March 2007 and December 2014 had been a perfect period for this to happen. In the historically long period of 7 years except during the brief period of several months during the global financial crisis, the oil price has been consistently above $80 per barrel resulting in huge demand for oil rigs. This, in a way, had benefited oil rig companies like Keppel Corporation and Sembcorp Marine. Orders were so huge that they have to be lined up even into 2018/2019. Of course, all the other peripheral companies supporting the oil rig industry also benefited as well. While general optimism spun across the industry at that time, many had overlooked an important point here. I believe easily 80% of these companies are in the business of oil-rigs or supporting the offshore oil industries. Their success hinged on only one condition – the oil price must consistently stay above $80 per barrel for the whole industry to flourish. If the oil price falls below $80 per barrel, many companies may not able to operate profitably. Whether these companies are cash rich or debt-laden, the top line would definitely be hit. Furthermore, the cost of each project is so high that taking on one or two of such projects would have easily soaked up the cash-flow of the company.

Worsening the situation is that the low interest environment had made borrowing extremely easy and this could have resulted in many companies borrowing heavily in hope that the global demand come banging again. Unfortunately, since December 2014, the oil price has been heading south, and problems started to surface lately. If my assessment of the situation is correct, I think even if the oil price managed to pass the $50-$60 per barrel mark, the shale oil industry will start to gear up and this will continue to block the oil-rig companies of getting back into the market. As a matter of opinion, I believe the management of Keppel Corporation understands this well enough and quickly restructure the company by acquiring Keppel Land and transform into a conglomerate rather than to depend heavily on oil-rig business. (Thanks to the Keppel Corporation CEO, Mr Loh Chin Hua, for his far-sighted vision.) Of course, this transformation came with a price, and Keppel Corporation is now more heavily geared. Sembcorp Marine, another oil rig company, has been less fortunate. As a subsidiary company, its hands were tied and it is harder to manoeuvre its way out from oil-rig and shipyard business. Needless to say, the profit margin suffered badly. Its profit shrank 90% in the second quarter compare to that in year 2015.

Going forward, my take is that it is unlikely to see extremely high oil price in the near future. By $50-$60 per barrel, shale oil will be in the market aggressively. They need to cover their developmental costs that they had made over the past few years! With most of the local companies in the offshore marine business, it is unlikely that this industry could pick up anytime soon. Companies who borrowed heavily in hope for better times ahead will be grossly disappointed. It is a situation of ‘when the tide ebbs, we know who is really swimming naked’.

The road ahead is likely to be long and winding in the days ahead for this industry. The next 18 months or so could be the real test.

Brennen has been investing in the stock market for 26 years. He trains occasionally and is a managing partner for BP Wealth Learning Centre. He is also the author of the book – “Building Wealth Together Through Stocks” which is available in both soft and hardcopy.

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