Crude Oil Collapse
Crude oil “contagion” has emerged (Q4 2014 – Q1 2015).
What are the issues?
a) World oil supply currently exceeds oil demand by c.1m-2m barrels per day. To address this oversupply/growing inventory, OPEC wants prices to reach “equilibrium” where supply = demand. Price gains require both supply cuts and higher demand to reach equilibrium and then move to a point where global inventories run down. A significant inventory run down could occur in 2016.
b) OPEC’s decision was to hold its supply at 30m barrels of oil per day from c.93m total demand. The thinking behind the November 27th decision to hold its quota, stemmed from its belief that high oil prices was stimulating non OPEC / US shale supply and contrary to OPEC long term interests. To sacrifice part of its quota would have bought time, but only temporarily delayed the inevitable price collapse as more supply is added over 2015-2016. A period of low prices now plays to OPEC’s low cost economics far better than higher cost producers (US, Russia). By deciding to “bite the bullet” now, OPEC should build its control of an oil market over 2015. Saudi Arabia, Kuwait and UAE are backing the Saudi Oil Ministry’s policy. Even the Saudi King expressed support and blamed the oil price collapse on weak global demand.
c) “Appeals” to Saudi Arabia from weaker OPEC members, Iran and Venezuela have fallen on deaf ears. The problem is many OPEC and non OPEC countries are facing immediate pressure on budgets and ratings. The collapse will result in rating downgrades for OPEC members and other “petrocurrency” countries.
d) Demand for Gulf crude oil is sensitive to GDP factors in China and SE Asia. Since 2012, the importance of the USA as a destination for Gulf oil has diminished leaving the Gulf very reliant on China/ Asian demand. The problem for OPEC is that any weakening in Chinese demand could greatly damage crude oil (sub $40). It seems the Saudis want to keep Chinese demand in a holding pattern via the discount system whilst OPEC tackles higher cost production.
e) The Q4 2014/ Q1 2015 collapse in crude oil prices has been of such magnitude that it has destabilised base metals including copper, iron ore and metallurgical coal. High inventories in these commodities also reflect weaker demand from China due to the property reversal and economic reorientation.
f) Ongoing suspicion of a geopolitical agenda. There are clear parallels with 1986 when Saudi Arabia deliberately cut crude oil prices causing the USSR to start borrowing heavily. By 1990 the USSR was bankrupt. Current policy could reflect a ploy by the United States to destabilise Russia. In this scenario Russia is forced into austerity and a withdrawal from overseas adventures.
g) Will it work? Our view is it will hurt the growth in US shale but in terms of knocking out significant global production this will take longer than the operation’s duration. OPEC next meeting in June 2015 will review progress.
Likely Winners of Low Oil Prices:
Transport companies and consumer / leisure sectors.
Likely Losers of Low Oil Prices:
All members of OPEC but in particular the “soft belly” of OPEC, countries like Venezuela and Iran. Oil majors and oil explorers whose business model involves significant exploration spending relative to their balance sheet.
Two Recommendations: What does it mean for Cairn Energy and RD Shell?
Cairn Energy (CNE) – SELL
Cairn Energy is a UK 250 quoted oil and gas company whose principal asset is a 10% shareholding in Cairn India Ltd – a large oil producer in the Indian state of Rajasthan. Cairn sold 58.5% of Cairn India to Vedanta for $8.67bn in August 2010.
Since then Cairn has pursued new exploration programmes in Greenland, the UK North Sea, Senegal, Morocco and Mauritania. Cairn Energy has proven and probable reserves of 56.1m barrels of oil equivalent and $869m of net cash (end December 2014).
| Company | Cairn Energy |
| Share Price | 184 |
| Target Price | 150 |
| 52 Wk Hi/Low | 266/143 |
| Shares O/S | 576.26m |
| Market Capitalisation | £1.06bn |
| Avg Daily Volume | 2.65m |
| Dividend Yield | 0% |
Source; Fidessa plc
| Key Catalysts
The Senegal exploration programme is complete with two discoveries (FAN 1 and SNE-1) which will move to appraisal in late 2015. Both of these new assets add significant potential, having a 20%-30% probability of commercial success. The Catcher field in the UK North Sea sees development drilling start in 2015 with first oil in 2017. The North Sea assets, principally Catcher and Kraken are high cost fields, a worry.
However the problem in India remains significant and an early exit from the balance 10% holding is looking less likely. The concern is such a release may be dependent on punitive taxes on the remaining asset.
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Key Factors in Support of Recommendation
i) Downside risk to earnings, balance sheet, and returns in the current price environment.
ii) Cairn Energy tax liabilities in India are uncertain and the effective block on the sale of its residual 10% stake in Cairn India is a significant problem for Cairn Energy’s value creation.
iii) General exploration strategy is high risk given Cairn’s balance sheet.
Key Factors Undermining Recommendation
i) The oil price environment might improve due to higher demand/ equilibrium being reached in a quicker timeframe than envisaged
ii) Cairn Energy is likely to reduce its capital spending relieving pressure on its balance sheet
Royal Dutch Shell (RDSB) – SELL
RD Shell is global oil major with significant oil producing assets in diverse global locations. RD Shell announced divestments worth $13.85bn in 2014 with $5bn of further asset sales expected in 2015.
Whilst significant $2bn cuts in exploration expenses are likely in 2015, the total capital expenditure is expected to fall only $4bn to around $31bn from $35bn in 2015.
The main problem is Shell’s margins; operating expenses per barrel have jumped to around $31 per barrel from around $6 in the last decade. On the assumption of 50% taxes on upstream profits, and including other costs, a $50 crude oil price yields only around $5 profit per barrel.
| Company | RD Shell (B) |
| Share Price | 2197 |
| Target Price | 2000 |
| 52 Wk Hi/Low | 2592/1989 |
| Shares O/S | 2440m |
| Market Capitalisation | £53.64bn |
| Avg Daily Volume | 3.59m |
| Dividend Yield | 5.23% |
Source; Fidessa plc
| Key Catalysts
RD Shell and Qatar Petroleum cancellation of the Al Karaana petrochem project signals a more muscular approach to capital spending in the new environment. There appears to be a number of issues ahead of Q4 (Jan 29th 2014) notably:-
Alterations to dividend policy to allow for the current environment |
Key Downside Risks to Price
i) Significant downside risk to earnings, balance sheet, and returns on equity in the current low price environment. The board have said Shell’s earnings decline c.$3.5bn per $10 price drop.
ii) Royal Dutch Shell is unlikely to raise its dividend from 2014 levels in 2015 or 2016.
iii) Royal Dutch Shell could use the current environment to continue to make impairments to its asset portfolio, reducing its balance sheet.
Potential Upside factors to Price
i) The oil price environment might improve due to higher demand/ equilibrium being reached in a quicker timeframe than envisaged
ii) Royal Dutch Shell cost programme might result in cost savings that are significant in profit terms and reduce the expected decline in earnings.