Turn in the cycle
Identifying the trough of an industry cycle is more art than science. But two signals usually stand out. First, it helps when competitors in a sector cease tearing each other apart. Secondly, look out for meaningful cuts in capital spending. If these two conditions are in place, then profitability and shareholder returns should begin to improve.
This framework is useful for understanding recent developments in the oil industry, which has experienced a savage downturn over the past couple of years. Over the weekend, when OPEC members met in Doha, it looked for a moment as if oil-producing nations had come to their senses. Those talks fell apart. Still, cuts in energy investment have been so severe of late that Doha’s failure probably won’t make much difference. If that’s the case, the recovery in the oil market which began earlier this year is set to continue.
At first glance, conditions in the energy industry appear ripe for cooperation. Cartels typically become effective when competition is seen to have harmful consequences. There’s no doubt that major oil producers are suffering. Venezuela is teetering at the edge of fiscal and social collapse. George Soros expects Russia to default next year. Even Saudi Arabia has been downgraded by the credit-rating agencies.
Just because it makes sense for OPEC to impose some discipline on the oil market doesn’t make cooperation inevitable. Sectarian rivalries have long trumped rational behavior among Middle Eastern protagonists. The immediate consequence of the failed Doha talks was a fall in the oil price – Brent dipped sharply before settling down 2.5 percent on Monday.
So much for cooperation. But what about the oil industry’s supply side? Industry downturns are perpetuated when producers respond to falling prices by raising output. For instance, when the oil price collapsed in the mid-1980s, Saudi Arabia boosted output by around 5 million barrels of oil a day. The intention was to maintain the kingdom’s revenue in the face of falling prices. It could do that because back then the Saudis had plenty of spare capacity.
This time is different. Having ramped up production last year by around half a million barrels per day, the Saudis may be operating at near full capacity. They threaten to crush the oil market with further increases in production. But this looks like a bluff.
Nor is it clear that any other of the top oil producers is in a position to meaningfully boost production. Both Iran and Iraq have dilapidated infrastructure which requires further investment if oil exports are to increase. Libya, Venezuela and Nigeria are engulfed in political turmoil. In these countries, outages are more likely than increased oil production.
Outside OPEC, both Russian and Chinese oil output may have peaked. The same is true for peripheral producers from the North Sea to Kazakhstan. Speaking at a Grant’s Conference in New York on April 13 an experienced energy investor argued that oil output from OPEC and other non-U.S. producers will be flat this year. This sounds plausible.
The real supply crunch is coming from the United States, where the fall in the oil price has led to massive investment cuts. The number of active oil rigs has fallen 75 percent from its peak. Having gorged on cheap credit during the bull years, a third of U.S. energy producers are now facing bankruptcy, according to Deloitte. Recoveries are set to be poor: Goodrich Petroleum has just filed for Chapter 11 protection citing liabilities 10 times greater than assets. Bankers are naturally wary of increasing exposure to this sector and the bond markets are likely to remain closed. Hundreds of thousands of workers in the U.S. oil patch have been laid off. In a strong labour market, they will be difficult to rehire if the industry ever picks up.
There’s a fear that a large number of drilled but uncompleted wells, or “DUCs,” threaten an overhang to the American oil market. But their number – down by a third in the last six months – is declining fast. This April, shale-oil production fell by more than 100,000 barrels per day in the United States.
A recent report by McAlinden Research Partners expresses the position of the U.S. oil industry succinctly: “The drastic reductions in E&P (exploration and production) spending, widespread job cuts, large-scale capping of oil wells, idle wells, decreasing yields from old wells, plus fewer drilling of new wells will shrink oil service capacity so much that future demand growth will not have adequate support. The ensuing supply shortage could force oil prices as high as double what they are today.”
Arguments that low oil prices are the “new normal” look mistaken. Capital-cycle analysis, which focuses on changes to an industry’s supply side, suggests a more bullish prognosis for oil. Forget OPEC. Around the world, oil investment has collapsed. Global energy production is set to fall. Having troughed in January, the oil price is heading upwards.