Crude oil prices hit a 5 year low and continue the downward spiral
Crude oil prices tumbled sharply last week on news of a disappointing OPEC meeting in Vienna. West Texas Intermediate fell 14% last week, ending Friday at a fresh 5 year low of $66.69 per barrel. Consensus among energy traders is that crude oil has yet to find a bottom and will likely fall further in the following months.
The crude oil market is currently oversupplied by an estimated 1.5 to 2 million barrels per day. As countries like Libya, Iran, Canada and the United States continue to increase production, energy markets were looking to OPEC core members, particularly Saudi Arabia, to voluntarily cut production and allow the market to absorb the excess.
But last week's OPEC meeting was most likely just a convenient excuse to hit the sell button. Crude oil prices ran up to almost $108 per barrel last spring on supply concerns from the Ukraine invasion and on-going turmoil in the middle east. Of course, none of the supply disruptions materialized. World oil production has climbed faster than anyone anticipated. Libya continues to rebuild its energy infrastructure after the last civil war, slowly creeping back to its pre-war production rates. Iran continues to increase oil exports as sanctions are slowly lifted and will likely be lifted further. US oil production has risen exponentially, now producing 9 million barrels per day thanks to the shale revolution. Faced with this unrelenting supply glut, energy traders have been liquidating positions since late spring. Prices are down almost 40% since June and will likely fall further.
So what can we learn from history?
The past 30 years have seen 3 major price corrections:
- 1986: A eerily-similar glut in crude oil supply caused prices to tumble 68% over a span of 6 months.
- 1991: The 1990 Persian Gulf War caused a temporary spike in oil prices; once the war was over, the air came out of the crude oil market and prices fell back to more normal levels. The 5 month decline saw a 58% price drop.
- 2008: Unprecedented growth in emerging markets and concerns over "peak oil" caused energy prices to spike to almost $150 per barrel in 2008. The subsequent collapse of world financial markets caused a 77% decline by early 2009. Prices quickly rebounded within a year, going back above the $70 per barrel level.
The supply glut of the 1980s came after the energy crisis of the 1970s, when oil shortages caused great strain on North American economies. The world responded by producing more oil and reducing consumption. This led to a short-term oversupply that brought oil prices back to $10 per barrel by 1986.
The price drops of 1991 and 2008 were slightly different; both were precipitated by sharp increases in prices which had little or no basis in fundamental supply/demand. The sharp price drops that subsequently followed were simply a function of speculators exiting the oil market as quickly as they piled in. After the collapse in oil prices, prices returned to a more normal level, more in-tuned with supply/demand fundamentals.
So what does this mean for today's crude oil prices? The run-up in oil prices to a high of $108 occurred in spite of signs of oversupply. Slowing economic growth in Asia has crimped world oil demand, failing to absorb the extra crude oil being produced in North America. In short, the world is producing too much oil and production needs to decrease.
So which country will cut back on oil production?
Countries like Russia, Venezuela, Nigeria and most of the Middle-East rely on crude oil exports for over 95% of their operating budgets. It is therefore highly unlikely any of those countries will cut production. In fact, history shows that lower crude prices actually spurs more production as oil producing nations try to make up for the lower revenues.
So who does that leave? Mostly likely, North America. Canadian oil sands deposits have a very stable and reliable production profile, normally in the order of 40 years. However, US shale deposits have a very high depletion rate, requiring constant drilling and relocation of rigs. As prices drop, exploration will likely slow, reducing crude oil production rates. If prices fall any further, expect the US Energy Information Agency (EIA) to dramatically reduce its forecast for US oil production growth.
What do lower oil prices mean for Canadian oil producers?
Most of the growth in Canadian oil production comes from the oil sands. As previously noted, oil sands deposits are very long lived and have a very stable production profile over a long period of time, without the need for further exploration. Although low oil prices can slow down production growth for new facilities, it is unlikely to affect facilities currently in operation.
However, from a financial perspective, oil sands producers vary greatly.
Integrated Energy Majors
Large integrated energy companies are the least affected by falling oil prices. Since the price of crude oil is both an input and output, this helps buffer the pain of falling oil prices. The refining side of the business makes money on the price difference between crude oil and refined products, such as gasoline and diesel (commonly referred to as the crack spread). Large energy majors have a more diversified portfolio and generally lower debt servicing costs. Two such examples on the TSX are Suncor Energy and Imperial Oil.
Large Oil Producers
Non-integrated large oil producers are in a slightly less favourable position. Without significant refining capacity, upstream oil producers are more leveraged to the price of crude oil. Two such examples on the TSX are Canadian Natural Resources (CNRL) and Cenovus. Although both are very large producers, CNRL is a more diversified company, with a mix of natural gas, conventional oil, off-shore, in-situ oil sands and mining assets. Although mining facilities are the most expensive to operate, a diversified portfolio helps keep the average operating cost per barrel down and allows the company better flexibility on capital expenditures. Cenovus is also a large oil sands player, but more narrowly focused on in-situ production. Cenovus is highly leveraged to the price of Western Canada Select, which currently sells at an $18 discount to West Texas Intermediate. However, in-situ facilities tend to have an operating cost of $15-20 per barrel, which would keep Cenovus cash flow positive at much lower oil prices. Much like CNRL, large energy company such as Cenovus have better flexibility in redistributing or deferring capital projects until the price of crude oil recovers.
Oil Sands Pure Play with Big Dividends
Oil sands pure play Canadian Oil Sands has one of the highest operating costs in the business. Syncrude's oil sands mine has an operating cost in the $40-50 per barrel range, making it one of the more expensive producers in the oil patch. However, the sweet blend of synthetic crude oil produced gets a small premium over West Texas Intermediate.
Although the company can remain profitable at much lower oil prices, Canadian Oil Sands currently pays out a 9.5% dividend, which represents a major portion of the company's free cash flow. Investors should prepare themselves for a dividend cut, which would likely put further downward pressure on the stock. This is perhaps already factored into the share price; Canadian Oil Sands stock hit a 5 year low on Friday.
Small Players with High Debt Loads
Arguably, the highest risk players in the Alberta oil sands are small cap companies with high debt loads. Two such examples on the TSX include MEG Energy and Connacher Oil and Gas. Although cash flow from operations can be sustained at lower prices, many of these companies have higher debt loads, in some cases US dollar denominated. They also tend to pay higher interest rates than larger energy companies. As the Canadian dollar falls, the portion of free cash flow directed to servicing debt gets larger, often resulting in a net operating loss at lower oil prices.
Although small cap companies pose bigger risks, its worth noting smaller companies can yield bigger rewards. When prices fall, they fall a lot harder than the larger players. When prices rebound, they can bounce back faster and provide better returns. Small companies are also susceptible to takeovers, which can produce a handsome return for shareholders if taken over at the right price. As always, with bigger rewards come bigger risks. Investing in small caps in the midst of falling oil prices can be a bit of a lottery ticket.
If crude oil prices continue to decline, investors should prepare for lower profits, reduced or deferred capital expenditures and likely some dividend cuts. Current consensus in the energy patch is that lower prices are likely ahead in the short term. The Alberta government is projecting a long term crude oil price closer to $70 per barrel. If crude oil continues to fall, traders should look for energy stocks that fail to hit new lows; this might indicate short term support and an good entry point.
Of course, nothing is guaranteed and crude oil prices could bottom and start to climb. An unexpected production cut or major supply disruption could quickly cause prices to spike. Although no one thinks prices will climb back to $100 per barrel in the near future, commodities are highly volatile and never fail to take investors by surprise.