Who Will Survive Low Oil Prices?

Something has gone very wrong with the oil market. It is not that the price of crude has fallen from over $100 a barrel to less than $40 a barrel. Instead, it is that free marketers are crying foul over the audacity of Saudi Arabia to allow oil prices to find their own level.

It would seem that these critics would much rather that the Organisation of the Petroleum Exporting Countries (OPEC) keep prices artificially high in order that inefficient operators can continue to make money.

The reality for some of these less productive drillers, frackers and free marketers, however, is that they have been given an object lesson in simple economics. They have been taught that price leadership matters.

Reality check

Unless every player toes the line or be able to produce at prices dictated by the price leader, they face some painful choices. The options on offer are either to run their pumps at a loss, until their available capital is exhausted, or cut their losses by shutting down their operations immediately.

Price leadership can be a powerful force, as every O-level student of economics knows. It can be a positive for every player in an industry, if the price leader chooses to set a high price. After all, every competitor can then justifiably raise prices – above their cost of production – without any risk of losing market share.

It can also improve profitability for just about every operator in the sector – even the least efficient ones. But if the price leader chooses to reduce prices – for whatever reason – then any operator that is unable to follow suit could be wiped out, as losses mount.

Crystal ball

The existence of a strong price leader in the oil industry, such as Saudi Arabia, underlines one of main difficulties of predicting prices for the commodity.

As much as analysts would like us to believe, their predictions of oil prices have been about as accurate as a broken watch. The only difference is that at least a broken watch is right twice a day.

One investment bank once predicted that oil could rise to $200 a barrel, before it didn’t. Now it is predicting that it could go to $20 a barrel. Time will tell whether they are right. But we shouldn’t hold our breath waiting for it to happen.

The trouble with forecasting oil prices is that it whilst it might be possible to gauge economic demand around the globe it is never that easy to accomplish the same feat with supply.

Risk aplenty

Nor is it possible to try and predict geopolitical risk, political allegiances, and the value of the US dollar or weather conditions, all of which can impact the price of oil. But it is the relationship between supply and demand that will ultimately determine the price of oil.

When supply exceeds demand, prices fall. When demand exceeds supply, prices rise. Given that we are where we are, it is perhaps instructive, from am investing perspective, to figure out what could happen from here.

Saudi Arabia has almost certainly set out its stall at the last meeting of OPEC. Or as one observer commented: “It is now every man for himself.

Saudi Arabia has decided, in the face of mounting criticism from other OPEC members and almost everyone else apart from consumers, to keep its taps open rather than cut back production, which would have pushed up prices.

Conspiracy theory

Many have speculated as to why it would want to do that, given that it needs to balance its own national budget requirements as well as balance the needs of global demand.

These include conspiracy theories over a liaison with the US to wreck the Russian economy; its desire to maintain market share and a self-inflicted painful strategy to snuff out the nascent American shale oil industry. Any or all of the above are plausible.

However, the reality is that prolonged low prices could see oil production fall in the US. It is also feasible that many projects, including those in OPEC countries could be either cancelled or shelved indefinitely.

Hunker down

The impact on oil services companies such as Keppel Corporation (SGX: BN4) and Sembcorp Marine (SGX: S51) could be painful, as it is not easy to determine how long this could take. However, the cut in exploration and production, whilst demand is still rising, albeit slowly, could eventually send oil prices higher again.

A protracted price war could also result in some oil explorers either exiting the industry or forced to consolidate with other players to improve efficiency. That could prove to be a good opportunity for some of the well-financed integrated oil companies to pick up prime assets at fire-sale prices.

As investors, we should be prepared to hunker down for the long haul. Saudi Arabia is playing the long game, in which the fittest will survive. That is the way it has always been, and the way it always will be.

A version of this article first appeared in The Independent on Sunday.

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