The Oil Price Shock: Primary, Secondary and Collateral Effects by Aswath Damodaran, Musings on Markets
In the last few weeks, financial markets have been rocked by the drop in oil prices, and in the process reminded us of three realities. The first is that for all the money that is spent on commodity price forecasting, there is very little that we have to show for it. The second is that all large macroeconomic events create winners and losers and the net effect of this oil price change, whether positive, neutral or negative, may take a while to manifest itself. The third is that investors are generally ill-served by either panicky selling of all things oil-related or the mindless buying of the most beaten-up oil stocks.
Oil: Prices drop and uncertainty climbs
At the start of 2014, the price per barrel of Brent crude oil was approximately $108/barrel, following three years of prices higher than $100/barrel. In fact, there seemed to be little reason to believe, given signs of economic recovery in the United States, that oil prices would drop any time soon. A combination of mild demand shocks (with reduced demand from China) and more noticeable supply shocks conspired to create the price drop, starting in September, accompanied by more uncertainty about future prices:
While much of the attention has been directed at the 40% drop in oil prices, the tripling in implied volatility in oil prices is a worth paying attention to and as I will argue later, could have an effect on not just oil stocks but on the overall market.
The initial stories about the oil price shock were almost all positive, suggesting that lower gas prices would allow consumers to spend more money on retail, restaurants and other businesses, thus boosting the economy. In the first two weeks of December, though, there was an abrupt shift in mood, as the same journalists who were lauding the oil price drop a few weeks ago were pointing their fingers at it as the primary culprit behind worldwide stock price declines in those weeks.
The Clueless Trifecta: Forecasters, Companies and Investors
The most sobering aspect of the oil price collapse is that is truly came out of nowhere, with none of the economic forecasters at the start of 2014 predicting the magnitude of the drop. In early 2014, Bloomberg’s survey of the “most accurate” oil price forecasters yielded a forecast of $105 for oil prices for the year, illustrating that “accurate” is a relative term in this market. In a Reuter’s poll in December 2013, which surveyed analysts about oil prices in 2014, the lowest price forecast was $75 by Ed Morse, Gobal Head of Commodities Research at Citibank and a longtime bear on oil prices.
If you believe that oil companies, being closer to the action, were prescient, you would be wrong. Early in 2014, Chevron announced that its budgeting would be based upon oil prices of $110/barrel, with John Watson, the company’s CEO, stating, “There is a new reality in our business… $100/bbl is becoming the new $20/bbl in our business… costs have caught up to revenues for many classes of projects.” and adding that, “If $100 is the new $20, consumers will pay more for oil.” Chevron was not alone in this assessment and oil companies globally made investment, acquisition and production decisions based upon the assumption that triple-digit oil prices were here to stay, which explains why at a $60 oil price or lower, almost a trillion dollars in investments made by oil companies were no longer viable. Looking at airlines, where fuel costs represent a large proportion of operating expenses, there is evidence that fuel hedging follows the oil price, rather than leading it. Fuel hedging peaked in 2008, just as oil prices peaked, and have tracked oil prices down in the years since.
Completing the clueless trifecta, investors have also been behind the curve on oil prices. Institutional money continued to flow into oil stocks for most of the year and flowed out only in the last quarter as oil stocks tumbled. The so-called smart money did worse, with hedge funds among the biggest losers in oil stocks, with big names like Icahn and Paulson leading the way with big money-losing bets. If there is any good news for oil price bulls, it is that oil forecasters are now predicting lower oil prices next year, oil companies are reassessing their assumptions about a normal oil price, airlines are reducing or even suspending their hedging and institutional investors are fleeing from oil stocks. Given their collective track record, this may be the best time to bet on rising oil prices.
The Biggest Losers
When oil prices drop, the most immediate impact is on oil producers and the ecosystem that serves them, including equipment and service providers. Within this group, though, the effect can vary depending on geography, size and leverage, as we will see in the nest section.
a. Companies in the oil business
The effect of an oil price change on a oil producing company may seem obvious, but it goes beyond the effect on revenues and earnings in the near term. By changing the payoff to growth and the risk in the company, a change in oil price can have a multiplier effect on value.
With these effects in place, you should expect the most negative effects of declining oil prices to be at highly levered oil companies with costlier reserves and higher fixed costs.
Let’s look at the numbers. In the last three months, as oil prices have dropped, oil company stocks have taken a pummeling, losing a jaw-dropping $1.7 trillion in market capitalization, as evidenced in the table below, with companies broken down into different sub-businesses:
Note that the companies at the production and drilling end of the oil cycle have been hurt the most by lower prices, while the companies that have been hurt the least are at refining and distribution end. Within the oil business, the damage also varies across companies. Breaking the numbers down further, here is what we see:
Smaller, lower-rated companies have been hit harder than larger, investment-grade companies, with the carnage being greatest for Latin American companies. In the only surprising (at least to me) finding, firms with the highest profit margins (in terms of EBITDA/Sales) have seen bigger losses in market value than firms with lower margins. Note that I was using this measure of profitability as a rough proxy for the cost of reserves owned by companies, since you should expect companies with higher cost reserves to be hurt more by lower oil prices than those with lower cost reserves. As higher oil prices have induced companies to explore for and develop new reserves, the cost of extracting oil is much higher at some of the newer reserves, as this chart for just shale oil reserves in the US indicates:
I would take the breakeven prices that analysts report for