Can oil prices continue upward trend?

One of the questions haunting exploration and production (E&P) companies is how soon and how much oil prices will go up by end of this year? Te reply is simple, hike in price is dependent on how much output producers are willing to relinquish.

Therefore the first point to explore is who will take the lead in cutting down output first.

The western media is still keeping the hype that Saudi Arabia has to cut its output but the biggest stumbling blocks are Iran and Iraq. It continues to spread disinformation that since Saudi Arabia and Iran continue to be the worst foes, any reduction in output by Saudi Arabia remains a remote possibility.

According to a Reuters report, "Oil rose to a one-year high on optimism regarding a future agreement between OPEC and major producers to restrict output"

It also said, "Significant doubts whether they (production cut targets) will actually be fulfilled due to the rivalry between OPEC members, who are fighting aggressively for global markets share, could prevent an effective deal.”

As per report, Goldman Sachs said in a note to clients on Tuesday that despite a production cut becoming a "greater possibility", markets were unlikely to rebalance in 2017. The rationale was, "Higher production from Libya, Nigeria and Iraq is reducing the odds of such a deal rebalancing the oil market in 2017 and even if OPEC producers and Russia implemented strict cuts, higher prices would allow U.S. shale drillers to raise output.

Initially, I had a point of view that most of the shale oil producers were unable to continue production below US$50 barrel due to accumulated losses. Now, believe that they have withstood the test, which is evident from the persistent increase in tnumber of active rigs. However, the number of operating rigs is still less than 25% of total installed rigs.

Moral of the story is that shale oil producers are more anxiously awaiting hike in price but out of desperation they want to increase the number of operating rigs and snatch Saudi share as early as possible. They have invested billions of dollars hoping that oil price would not fall below US$50/barrel. The crash that began in 2014 has shattered their dreams. Even geopolitical turmoil in MENA has failed in deterring OPEC members, mostly located in the region where proxy wars have been going on for more than last two years.

Why analysts are talking about declining oil prices only?

Somewhere I read a story about the energy giants ‘seven sisters’ which virtually control the global economy. All analysts are talking about declining earnings of these companies but not about the benefits of low oil prices. The same is also true about Pakistan where analysts are too worried about earnings of less than half a dozen oil & gas exploration companies but hardly demand the government to stop persistent hike in taxes on petroleum products.

A few months back I raised a question in one of my blogs, who are the beneficiaries of declining oil prices? At that time my own inference was that the US is the biggest beneficiary, being the largest consumer of energy products. After lapse of a few months I still withstand my point of view. I even go to the extent of saying that not only all other oil producing countries are plunging into serious financial crisis but Saudi Arabia and Russia are worst hit. Lower oil prices may keep proceeds from oil export low for Iran but it may gain the most after easing of sanction it had endured for more than three decades. Its non-oil exports are likely to increase substantially and it may also succeed in attracting enormous foreign direct investment in virtually every sector. 

Declining oil prices have enabled the US in increasing its strategic reserves, oil imports remain high and indigenous oil production still hovers at record high levels, above 9.2 million barrels a day. Reportedly the US crude inventories have surpassed the 500 million barrels milestone. Two of the global benchmarks WTI and Brent bounced up and down throughout the week ended on 5th February. However, faltering global economies offer a chance to the US Fed not to hike the interest rate, resulting in weak dollar and pushing oil price higher again. 

The western media is now trying to create an impression that the collapse in oil prices is now bleeding over into the broader global economy. They talk about the ongoing down turn in oil exporting countries, from Saudi Arabia to Russia, Venezuela, Iraq, Nigeria, and more. They have strange rationalization that cheap energy should bolster consumption, but the drop in commodity prices has been so sharp that questions continue to arise about the creditworthiness of some oil producers, Venezuela tops the list. With billions of dollars in debt due this year a rapidly shrinking ability to deal with the crisis, a debt default may not be too far off.

Citigroup added its voice to those concerned about the health of the global economy, citing four interlinked forces – a strong U.S. dollar, low commodity prices, weak trade, and soft growth in emerging markets – for the sudden fragility and potential for a global recession. "It seems reasonable to assume that another year of extreme moves in U.S. dollar (higher) and oil/commodity prices (lower) would likely continue to drive this negative feedback loop and make it very difficult for policy makers in emerging markets and developing markets to fight disinflationary forces and intercept downside risks," Citigroup analysts warned.

ConocoPhillips (NYSE: COP) made news this week when it became the first US-based oil major to slash its dividend. Italian oil giant Eni (NYSE: E) was the only other oil major to have done so – it cut its dividend almost a year ago. ConocoPhillips cut its dividend by 65 percent this week, and the company’s CEO argued that the move would save $4.4 billion in 2016.

The oil majors are having trouble covering spending and also their shareholder payouts with their underlying cash flow. By and large, they are making up for the shortfall with new debt. Chevron took on an additional $9.6 billion in debt to cover dividend obligations, ExxonMobil added $10.8 billion in fresh debt, and BP took on another $4.6 billion. At some point, something has to give. S&P downgraded a long list of oil companies this week, including Chevron and Shell. It also put BP and ExxonMobil on review for a possible downgrade.

A quick rundown of the full-year earnings from some of the oil majors:

•    BP (NYSE: BP) lost $6.5 billion in 2015, one of the company’s worst on record.
•    ConocoPhillips (NYSE: COP) posted a loss of $4.4 billion in 2015.
•    ExxonMobil (NYSE: XOM) saw profits halve to $16.2 billion.
•    Royal Dutch Shell (NYSE: RDS.A) posted a profit of $3.8 billion, down 80 percent from 2014.
•    Chevron (NYSE: CVX) reported a loss of $588 million, its first loss since 2002.

Impact of low oil prices on Pakistan

In its latest meeting OPEC decided to maintain its oil output. This has triggered another slide in global crude oil prices. There are growing expectations that prices may remain low for longer than expected period.

One of Pakistan’s leading brokerages houses has analyzed possible implications of lower oil prices on the local stock market under three oil price assumptions of Arabian Light crude (WTI and Brent are less related to Pakistan as the country buys crude mainly from the Middle eastern countries. The brokerage house has based its analysis on three assumptions: 1) US$35/bbl, 2) US$40/bbl and 3) US$45/bbl) against its base case of US$50/bbl.

Remaining a key positive on the macro front, significant improvements are expected on 1) the BoP position on lower oil imports and 2) controlled inflation opening up room for continued monetary easing.

However, from the market's perspective this scenario will be a drag on index heavyweight Oil & Gas sector. Additionally, lower interest rates will continue weighing on banking sector's performance, however boding well for leveraged plays and high dividend plays.

Pakistan continues to benefit from lower oil prices, where another slide in the commodity's price holds positive implications for the country. Sensitivity analysis undertaken by the brokerage house indicates that with US$5/bbl reduction in CY16 will result in additional import bill savings of US$8 million/annum where oil averaging below US$45/bbl could comfortably lead to current account surplus for FY16.

Besides helping to sustain recent improvements in the BoP position, lower oil prices also have trickle down benefits on inflation, which can sustain at current levels (2.5%YoY average in CY15) across the medium term. With lower fuel costs and indirect impact on food, the sensitivity analysis indicates CY16 CPI average can hover in the range of 2.8% to 4.2%YoY.

A downwards trend in oil prices can effectively counter the low-base effect on CPI numbers, unlocking room for further monetary easing. While room could exist for a rate cut at US$45/bbl average. It is expected that the central bank may remain cautious with potential and discount rate may hover around at 5.5% at the lower extreme.

Pulled lower by falling global oil prices, Oil & Gas companies have experienced broad based selling (down 33%CYTD). E&Ps suffer from hampered profitability with POL being the most affected on account of high oil price partiality (53% of revenues in FY15). That said, the gas heavy (80%+ of overall production, 1,173mmcfd in FY14) OGDC continues to persevere in the E&P sector as its profitability is the least hurt by tumbling oil prices. Volatility in oil prices and its consequent impact on the interest rate cycle is likely to have negative implications for banking sector's profitability.

For the Big-6 banks, this is most likely to reduce CY16 earnings by 5%-18% assuming the worst case scenario. However, factors such as potential increase in the capital gains backlog and any uptick in private sector credit growth are expected to provide support to bottom-line should the interest rates come down further. In this backdrop, banks with a higher CASA ratio, greater concentration towards high margin consumer/SME segments, and higher PIB/investment ratio are expected to fare better than the rest. 

While Oil & Gas and Banks are likely to bear the brunt in case of lower oil prices and continued monetary easing, brokerage house sees cost side benefits trickling down to sectors with 1) high leverage sectors like Fertilizers, Cements and Telecom 2) higher fuel and energy costs sectors like Cements, Foods ,Shipping and Aviation.

Apart from these, Power sector is likely to benefit from reduced liquidity constraints amid lower cost of generation while a lower interest rate environment should keep the sector in limelight on account of attractive dividend yields.