Feb 12, 2016

It has been a difficult year for the oil and gas industry; the continual collapse of the price of oil (currently below $30 per barrel, down from the $100 average from the past decade), while good for consumers, has left many oil companies without profits and, in many cases, bankrupt: the effect of the price drop has been felt throughout the economy. The International Energy Agency (IEA) has warned of severe oversupply while the International Monetary Fund (IMF) have reduced their predictions for global growth, which has many worried that we might be headed for another financial crisis. While it is unlikely to transpire into a full blown financial meltdown, it is doubtful that the price of oil will rise any time soon. Risk adverse and impatient investors should seek investment elsewhere. However, for those who are willing to wait, investment in oil could provide high returns in the future.

Why is the Price Falling?

The falling price of oil can be blamed on a number of factors, though it ultimately comes down to the basic economic principle of supply and demand. The global economy is still reeling from the 2008 crisis and low rates of inflation along with slow growth have hit demand from the US, Europe and China. Additionally, the low cost of fracking and a general increase in the level of energy efficiency worldwide has led to oil supply far outweighing demand. Furthermore, the US has become less reliant on imports, instead favouring domestic production of oil; however a strong US dollar and low market price resulted in slowed US production throughout 2015. Big oil producing states like Texas have been affected, with oil companies having to sell assets and lay off workers in order to save money.

The lifting of economic sanctions from Iran will further exacerbate the problem. It is estimated that Iran’s return to the market will contribute a further 500,000 barrels per day to global oil production (potentially reaching 1 million bpd by the end of 2016), widening ever further the gap between supply and demand. At the end of Q4 2015, the markets had a surplus of 2 million bpd. Many have called on OPEC (Organisation of the Petroleum Exporting Countries) to intervene and limit the supply to help stabilise the market, as they have done in the past. OPEC’s high market share allows them to dictate the price of oil by increasing or decreasing production and are also able to produce oil far more cheaply than others, allowing them to sustain a profit despite global oversupply. However, OPEC has stated that there will be no cut in production unless other producers (i.e. Russia) do the same. This may be an attempt to win market share from the US and other nations with higher extraction costs, or an attempt to profit in the long-term by giving fossil fuels a price advantage against renewable energy sources. Either way, it seems unlikely that prices will recover in the near future.

What does this mean for the Oil and Finance Industries?

Despite the negative consequences for the industry itself, the Bank of England recently published its view that the oil crisis has had a positive overall effect on the UK economy. Cheaper oil has reduced the cost of transport and production, decreasing the overheads faced by companies and households across the country, the effect of which has been to increase wages to real terms. Despite this fact, equity markets worldwide saw share prices slump in January with markets suffering some of the worst opening loses in history. Investors have subsequently moved away from commodities and equities, seeking more risk-averse options such as government bonds. In February, Shell and BP announced falling profits and job cuts totalling nearly 15,000. While Shell maintained dividend payments to shareholders this quarter, other oil companies have been forced to make drastic cuts to exploration spending, defer investments and sell assets to prevent bankruptcy. The oil industry has long been seen as a stable investment, and shares of oil companies have long been popular with pension funds. However, the bearish markets of late have caused a drastic reduction in the value of exposed portfolios.

For some, the drop in oil prices has been treated as an investment opportunity; after all, the oil industry has suffered worse losses and recovered. For those who believe the market performance to be a mere blip, it is a good time to get into the industry at a discounted rate. Share prices in oil companies are well below average and now may be a good time to invest if you are willing to wait a while to see a return. The price may fall further and remain low for a while, but most are predicting that it will rise eventually. However, investors in futures who have bet on the industry recovering in 2016 look set to lose out.

Investment banks are currently heavily exposed to oil industry loans and energy junk bonds (over 50% of which are currently at risk of default) and as the oil companies are suffering big losses, institutions need to prepare for the worst case scenario. As we have seen before, a mass default could trigger a wave of Credit Default Swaps, increasing systemic risk to the economy. Creditors and debt investors should be prudent in their lending and insist on proper covenant protection to ensure seniority of their claims in the event of default.

What does the future hold?

The outlook of the oil industry will not improve until either the supply of oil is limited or the demand increases. Only then will the price per barrel increase to a level that allows non-OPEC oil companies to sustain their operations. While it is highly doubtful that we will see a return to the triple figure cost per barrel anytime soon, it will probably rise in the future as producers cut costs to increase profits. The current low cost per barrel will decrease appetite for investment in renewable energy and increase demand for oil. As the price increases, the industry will be able to revisit plans for exploration, thus creating jobs and boosting investor confidence in the industry (and profits for those who were brave enough!). The oil industry, though experiencing a lengthy period of lean times, will likely bounce back.