sorting out oil-related stocks

The very large drop in oil prices over the past eight months has had negative effects on all oil-related firms.  The amount of suffering varies considerably, however, based on how a given firm is involved in the hydrocarbon business.  Here’s my take on the various sub-industries:

1.  oilfield services companies.   It’s a general rule in business that when a manufacturer slows down, its suppliers feel more pain than the manufacturer itself.  This is true in the oilfields, as well.

–Lower output prices mean some new drilling projects are cancelled.  This is bad for the contract drillers who supply and operate the rigs that do the actual drilling.  Offshore, where projects are typically larger and more expensive–therefore riskier, is a worse place to be than onshore.  Worst hit of all are the suppliers of the oilfield services firms, like the companies that manufacture new drilling rigs.

–Suppliers of goods and services, from seismic analyses of prospective acreage to drilling mud, are hurt as well.  Being in support for development of existing projects is better than being involved in new exploration.

2.  high-cost alternatives   …like liquefied natural gas (LNG) or tar sands.  Projects may no longer be economically viable.  I think LNG is more at risk.  Transporting natural gas from, say, the US to the EU or from Australia to Japan requires a multi-billion dollar investment in plant and equipment to liquefy and ship the gas to market (the alternative would be an underwater pipeline).  Because of this, I think new projects are non-starters in today’s world.  As for projects already up and running, we have no way of knowing how contracts are structured–that is, how the selling price of the gas is affected by the oil price drop.  This determines whether the pain of the oil price decline is borne by the LLNG project or by the utility customers who ultimately use the gas.

The situation for green alternatives, like solar and wind, is less clear.

3.  reserve valuations     The asset value of any oil exploration/production company depends heavily on the size and value of its oil reserves.  The lower oil price clearly hurts the value of reserves.  What’s less obvious is that reserves are defined as barrels of oil that can be brought to the surface and sold at a profit at the current price.  Some barrels that are economically viable at $100 a barrel may not be at $50.  If so, the size of reserves will also shrink.  In an extreme case, a company with a million barrels of reserves worth $50 million at an oil price of $100 might have 0 barrels worth $0 at a $50 oil price.

4.   US-based exploration companies     Smaller firms have been the leaders in shale oil production.  Generally speaking, they are hurt worse  by shrinkage in cash flow and downward revisions in reserve value than the big international firms.  To the extent they’ve borrowed to finance drilling, their problems may be magnified.  As a practical matter, however, there’s probably less scope for creditors to take action against a firm if it has issued junk bonds than if it has bank loans.

5.  international majors    The profits of these firms are more insulated against the price drop than their smaller rivals.  How so?

–They have petrochemicals and refining/marketing businesses that benefit from the lower price because they’re users of crude oil.

–They have fields they own that may have been operating for decades, and which therefore are still profitable at today’s prices.

–Also, in their deals to develop fields with national oil companies in foreign countries, they typically are paid a return on invested capital.  In other words, they don’t gain or lose much (if anything) as the oil price rises and falls.

No, they don’t escape unscathed.  They do lose from the lower price they get from production they own in the US and Europe, but their losses are much less than the pure domestic exploration and production companies.

6.   I haven’t looked at refining and marketing companies.  I assume that they aren’t fully passing along to their customers the benefits of lower crude oil costs, but I haven’t checked.

Of course, if/when the oil price begins to rise again (I don’t expect that to be any time soon), the most responsive stocks will likely be those of the oilfield services firms, with those of the international majors moving the least.

offshore contract drillers when the oil price is sinking

Last Friday, offshore contract  oil and gas driller Transocean Ltd (RIG) announced that in its September quarter earnings statement it would be taking an impairment charge of close to $2.7 billion, or more than a quarter of the stock’s market capitalization.  The reason:  deterioration of its business prospects caused by the recent sharp decline in the world oil price.

Despite this bad news, the stock closed down less than a percent on the day  …a trading session in which the S&P 500 ended basically unchanged.

Why the muted reaction?

Offshore contract drilling is a very capital-intensive business.  It can easily cost over half a billion dollars to build a state-of-the-art semi-submersible rig.  Contract drillers rent their rigs out under long-term contract to oil exploration and development companies at rates of tens of millions of dollars a year.

In good times, meaning when the oil price is rising,  rental rates go up as well.  Contract drillers tend to sink all their cash flow (often plus all they can borrow) into building new rigs.  This, of course, keeps both financial and operating their leverage high and eventually leads to overcapacity (as is the case in any capital-intensive commodity business).

In bad times, i.e., when the price of oil is falling, demand from the big oil companies wanes and rental rates fall.  Worse than that, customers seek to renegotiate down rental rates for rigs already under contract, or simply announce they don’t need the rigs any more and, contract or no, stop paying and return them.  Ouch!

The key variable in all this is the oil price.  Because of this, the stock market takes the spot price of oil as a leading indicator of the drillers’ future profits and trade on that rather than waiting for reported earnings.  Again, this is common in other commodity-like industries, as well.

The message I take from Friday’s price action is that, for the moment at least, the market expects the oil price to stabilize around current levels. Monday’s earnings announcement and conference call by RIG (I’m writing this on Sunday night) will be a further indicator of whether my view is correct.