Oil prices have finally found a floor, with Brent crude up 1% today and WTI roughly flat, but if there isn’t a larger rebound in the months ahead we could see double-digit default rates in an industry where debt has been accumulating on the assumption that prices would stay high. Even though this would put a lot of stress on the sector in the next few years, it could set up some big winners in the long run.
Oil prices undermined from multiple angles
In a recent presentation, JP Morgan chairman of market & investment strategy Michael Cembalest and head of global investment opportunities group Anton Pil explained that the sharp drop in oil prices was caused by lots of different factors coming together at the same time, some of them being more technical than fundamental. The easiest change to spot is the rise in American shale oil, which has grown from less than a million barrels per day to 4 million per day in about four years.
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This growth was offset in 2013 by falling production in Nigeria, Libya, Iran, and Iraq due to instability in the first three countries and sanctions against the fourth. That trend reversed this summer, bringing even more oil onto the world market.
But it’s not just a rise in supply, demand has been soft because global GDP growth has been disappointing for most of the last year, a measure that tracks the price of Brent crude pretty closely.
But some of the sharp drop is more technical, as speculators fled and hedging strategies kicked in.
“Oil prices likely rise over the next 12-18 months; the severity and speed of the oil price decline is partly related to hedging and derivative activity,” write Cembalest and Pil.
Oil companies with strong balance sheets could be big winners
Obviously that’s bad news for the oil industry, but it’s exacerbated by more than a decade of growing debt. The top 100 global energy companies have total debt of more than $1.2 trillion, up from about $250 billion in 2002.
We’re already looking at barely more than half the top 100 global energy companies with positive free cash flow, and if oil prices stay in the $60s industry-wide FCF will start to go negative, causing a high default rate over the next couple of years.
For value investors, this could be a great opportunity to find a long-term investment. A lot of oil production starts to be uneconomic in the $60s, so the price should have some support, as we’re seeing, and eventually supply should start to fall. Oil stocks are incredibly cheap relative to history right now, rand the ones that have strong enough balance sheets to survive whatever the next couple of years look like could come out winners once the industry has finished adjusting.