Oil price expectations and a house of cards
Oil prices yesterday closed at their lowest levels since February 2009, with Brent and WTI falling below $40 and $37 a barrel respectively. Whereas both indices went on to rally hard in 2009, Greg Bennett fund manager at Argonaut Capital believes a rally from these levels is not on the cards this time around.
At the beginning of this year the median oil price1 being used by analysts was $80 and $852 for 2015 and 2016 respectively. Currently they are using $55 and $582 – a significant 30% reduction in the most important modelling assumption (resulting unsurprisingly in wholesale negative earnings revisions). However, notwithstanding these significant reductions in earnings estimates, many of the underlying oil stocks (some E&Ps and most Integrateds) have remained resilient. We think this is because most analysts (and investors) continue to believe the oil price will be materially higher in the near future and thus are prepared to “look through” current weak earnings. This is supported by our recent survey of oil price assumptions being used by analysts in their models, details of which are shown in the table below.
Table 1: Median oil price assumptions being used in earnings models
Source: Argonaut, Bloomberg
It is clear from the table above that current earnings estimates (and all other valuation derived arguments) are implicitly assuming a 32% increase in the oil price next year and an impressive 59% increase by 2017, whilst an oil price 82% higher than today’s is being used to derive longer term earnings forecasts. With such assumptions it is relatively easy to make a “buy case” for most oil stocks. Analysts argue these assumptions are rooted in detailed cost and IRR analysis and reflect the oil price required to bring on marginal new fields to satisfy global demand. Whilst theoretically this may be true, we feel reality may be different. Is there really a pressing need to bring on new oil fields in the near term after global integrated companies have sunk $2.6 trillion3 into upstream capex projects in the last ten years (far above any levels of previous investment) and effectively rebuilding the world’s supply base? We think not. What counts in today’s environment is production costs, and this is critical to understanding the current dynamics in global supply.
Production costs represent the day-to-day costs of running an oil and gas field, with the vast majority of these costs being fixed. This has important implications for supply, as oil will continue to be pumped as long as production costs can be covered, and these production costs globally are estimated to be $15/boe4 for the world’s largest integrated oil producers (and lower for pure E&P companies). Importantly, this estimate excludes the OPEC national oil companies where it is estimated that production costs for some onshore fields are as low as $1-2/boe.3 Interestingly, given the high fixed cost structure, the most important element in lowering costs is volume itself (more barrels through the same cost base), putting further impetus on maximising near term production.
With investments in place and the not insubstantial costs of shutting down fields, it is not surprising that the focus is on maximising production and focusing on cash returns – resulting in significant overproduction and stock-building. Indeed the world has been over-producing oil every quarter from the beginning of 2014, with the degree of over-production rising rather than falling as the oil price has weakened. Specifically, since August 2014 (when oil was last over $100) to the end of October this year, global oil production has risen by 3.6mbbl/day.5 Interestingly, during this period the level of US shale oil production has risen by just 263k bbl/day,6 accounting for less than 10% of the overall increase. In fact the largest contributors to global supply growth over the last 14 months have been the OPEC nations of Iraq and Saudi Arabia, together with Russia, the US offshore Gulf of Mexico and Asia. Thus even if, as the IEA expects, US shale oil production falls by 600kbbl/day5 next year, this needs to be understood in the context of the world currently over-producing oil by 1.6mbbl/day,5 and where global inventories are at levels not seen for more than two decades.
This level of supply increase has had profound implications for the shape of the oil futures curve. The chart below depicts the shape of the current oil futures curve and how it has changed from August 2014 and since the start of this year.
Chart 1: Brent oil futures curves
Source: Argonaut, Bloomberg
The change into contango is clearly evident as supply pressures come on to the market, forcing spot prices lower. Whilst future prices are higher, the step change down is equally important, particularly when compared to what analysts are assuming and carrying in their models.
Table 2: Oil price implied by current futures curve vs current analyst assumptions
Once again, analysts seem to be overly optimistic in their future oil price assumptions. The clear risk is the oil price continues to stay at current levels (or lower) over the near term. Oil producers will not cut production due to the economics, whilst Saudi Arabia (as the lowest cost producer) is unlikely to initiate production cuts either until it achieves some or all of its strategic aims. If we are correct, it means that the most important modelling assumption (the oil price) used by oil analysts is incorrect which would mean significant downward revisions to earnings expectations and thus valuations for the sector. Equally, it will mean that recent acquisitions done and debt issued based on budgeted higher oil price assumptions by investment banks may not be as economically viable as first thought – a veritable house of cards.