The Bust in Oil May Only Be At the Beginning

The price of oil started falling dramatically in the last quarter of 2014 and in only a few short months, it has fallen by close to half. This fall has dragged the share prices of oil and gas-related companies down to the pits.

Falling share prices will always attract the attention of bargain hunters. But for those who are thinking of earning a quick buck through investing in depressed oil and gas-related companies, you might want to think harder about the decision.

There are signs that a recovery in the business of oil-related companies might still be quite some time away. Put another away, the bust in oil is just getting started.

The way I see it, there are five phases that need to happen before there can be a more sustained recovery in the oil industry: 1) Capital expenditure cuts; 2) job cuts; 3) production cuts; 4) bankruptcies or restructuring of the weakest players; and 5) consolidation.

So far, what’s happening now within the oil industry are big cuts to both planned-investments (the purchase of assets like rigs or refineries) and jobs. This parcel of information from a recent Bloomberg Business article is a nice summary of the events:

“The industry has responded by cutting more than 30,000 jobs, halting exploration projects and deferring investments in everything from gas-export terminals to petrochemical plants.”

The production of oil hasn’t really fallen by much as many production wells were drilled before the slump in oil prices took hold – it may take a while, but there’s a chance production may fall in the future.

In any case, the first three stages would mean lower levels of business for most oil-related companies. When the business environment deteriorates, that is when heavily-leveraged companies start to feel the pinch. And, in the oil & gas industry, there are no shortage of companies which are highly geared; the offshore support services providers Ezra Holdings Limited (SGX: 5DN) and Ezion (SGX: 5ME) are good examples.

In any case, the poorer business environment can then lead to a credit crisis happening within the oil industry as many companies now face an onerous task in trying to service their borrowings. This thus ushers in the fourth stage of the bust when bankruptcies start to happen.

As more and more of the financially shaky firms start struggling, mergers and acquisitions can happen whereby the stronger hands start consolidating their weaker peers. In my opinion, this needs to happen before we can see the oil industry undergo a sustained recovery.

Foolish Summary

Many companies in the oil & gas space have been expanding aggressively under the assumption that oil prices will stay high forever. If the price of oil can recover fast from here, then all may be well and good. But no one really knows what the price of oil will do.

And as I’ve illustrated above, if the price of oil remains low, we might only be at the early stages of the oil-bust. Punters hoping to speculate on a rebound in beaten-down oil companies need to go in with their eyes wide-open to all the risks involved. As for long-term investors, we might want to prepare for a long and bumpy recovery.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.