Article - Why Cheap Oil is Great for the Majors

My article from seekingalpha.com - as usuals based on the principles of value investing and dividend paying stocks

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For the last 3 years, the world’s oil majors have not had an easy time from the oil producing states. Increasing oil prices has led to a complacent attitude by oil reliant governments. This often masks inefficiency, sometimes corruption, and has led to high taxation coupled with unsound business practices. Russia's oil production for instance, has been reducing each year despite the governments desire to increase output. Easy credit and a speculative environment resulted in many new oil companies coming to the market, with high valuations and little, if any, proven reserves. As the oil price increased so did the tax receipts and so did the smaller companies share prices. This resulted in state influenced companies investing less and the global situation where finding new oil, or purchasing oil reserves, became ever more expensive due to the barrel price and the demand for people and equipment.

Times change, oil is now trading around $65 per barrel, a 16 month low, but still way above its 2002 price of $25. Prior to this it has not been higher than $30 since 1987. Was $25 artificially low? Have China, India and Russia really started using so much more oil in the last six years that oil should be substantially more than $25?

Who knows, but from a long term investment, the price can be ignored. The share price of the large oil companies does not fluctuate with the price of oil, and nor should it. Long term contracts and many different aspects to the business means the month-by-month barrel price makes little difference to revenues and earnings. A world recession will make a difference but the long-term case for building an investment over the next 12 months is compelling.

The current price of oil is very bad news for many of the OPEC countries, whose governments, or ruling factions, often manage to exist through maintaining social programs funded by oil receipts. Russia less so, but it’s hugely dependent on oil revenues and the health of the oil industry. These countries have followed the rest of the western world and spent while the going was good, but now it's a different story. Consider that to balance the books, Russia needs oil above $70, Iran and Venezuela need $80 and a similar figure for all the rest.

So what are the likely actions of oil producing countries, state influenced companies and the impact to the majors?

If we assume that the oil price continues to fall, or not recover, and that demand falls or production is cut, then none of this is good news for the oil states. In a slowing world economy it is likely that all three will occur. Apart from making life very difficult for the leaders of the countries dependent on oil, it is likely to result in less investment in the industry. When the economic cycle turns, as it will, they will turn to the majors to bring in expertise and assistance to increasing output and efficiency with a need to enter new or enhanced joint ventures. They will also be more open to providing access to possible reserves that they do not have the skill or experience to develop.

The majors will negotiate hard in any venture or partnership remembering the treatment received during the last few years, the obvious example being the tactics and problems encountered with the TNK-BP venture. For their own future planning, the majors use a long-term investment assumption of $ 30 - $40 per barrel, so any investments in their own business should not be too badly impacted by the lower barrel price. In addition the planned investments will not be competing for the physical and human resources that have been so scarce for the last few years.

This situation cannot be said, however, for the many small oil producers and explorers whose share prices are almost totally dependent on the prevailing oil price. Large oil companies are well funded and have access to credit, which many of these smaller companies do not, and this makes them highly vulnerable to being taken over at depressed prices by the majors, thus acquiring long term reserves at sensible prices. There is certainly no shortage of small companies, which have been funded by other people’s money, that now look attractive targets.

In the medium to long term, we are looking at a relatively healthy and well prepared commercial industry, with the state influenced sector under invested and in a weaker position. This might not be good for the economy as again it indicates supply and demand imbalances, but the oil major’s plan for volatile oil prices, they always have done and always will do.

So the fall in demand will impact the large oil companies, but this is a short term impact and many of these firms have been around for a long time and are used to planning for economic cycles. The cycle is key to the reason why these companies now make a compelling case for investment. If we assume that within 3 -5 years the world economy starts to grow again, and continues its upward path of growth, which it always has done, the long term benefits of cheaper reserves and under investment by others will be good for the future of the independent oil companies.

With good yields, strong balance sheets and a long term growing market, it gives a strong argument for investing into the likes of Exxon (XOM), Chevron (CVX), BP (BP) and Shell (RDS.A) over the next twelve months as a traditional buy and hold stock.