The OPEC deal announced last week helped to propel the price of a barrel of Brent Crude over the $50 mark, the highest for well over a year and almost double its January low. But prices have stalled since, underlining our view that this isn’t a one way ticket. So where next for oil?
A new price era?
Imagine a snake in a drain, wriggling up and down but unable to escape. That’s how we see the oil movements in 2017 – a volatile wriggle in a limited band. The first supply cut from OPEC in eight years should help provide a higher price floor than 2016. But, if prices move much above $60, extra supply will come online, limiting price increases beyond this point. A price between $40 and $60 would be a marked improvement on 2016 for the sector, but it’s still well below the average of the last 10 years. So surely it’s time we stopped talking about a ‘cheap price’ and started thinking about ‘new price’, since this reality isn’t going away.
Probably…. If the experience of the last year has taught us anything it is that we should anticipate alterative realities. The obvious is that some nations won’t comply with OPEC’s plan. The US market also offers multiple variables, from the viability of US shale, to the strong dollar to the new pro-oil US administration, which represents a wild-card in terms of supply and demand – as well as international relations.
Debt markets signal confidence in the floor
But, for now, capital markets at least seem to working on the basis of this new price band with a higher price floor. Talk elsewhere in bond markets might be about tightening, but oilfield services yields have fallen especially dramatically. Debt markets are certainly open. The FT reports that five energy deals were completed on Tuesday, taking sector debt sales in 2016 to around the same level as 2015. Although this figure was the slowest since 2010, which underlines the message that pressure on the sector has eased – not lifted.
Credit ratings agencies say downgrades are slowing, but defaults tend to lag the cycle and will continue to come through in 2017 before they dip later in the year. Higher prices won’t ease pressure quickly or evenly across the sector. Many companies are still struggling with high debt burdens with limited ability to reduce leverage – and this won’t be magically cured by $55 oil. In the last 12 months, 57 – or 20% – of US high-yield rated energy groups have defaulted, against 4.8% across all sectors. S&P has a further 55 energy groups on its list of companies most likely to default.
“Defaults are clearly a lagging indicator of the carnage in the industry….There are still more [defaults] to come before we see the plateau.” Diane Vazza, S&P
Companies remain disciplined
Where does this leave companies in the sector? Doing much as they did throughout 2016 – but with some subtle changes that reflect the new era. Our analysis of the top themes in Q3 oil & gas earnings calls – when oil was round $50 a barrel – showed companies expressing cautious optimism that the industry was at an inflection point. The sector isn’t taking the brakes off cost control measures, but there is an increasing focus on disciplined growth and finding new ways to deliver capital projects in this ‘new price’ environment, i.e. not just to cost and schedule, but in a way that can make uneconomic projects viable at this level.
Companies are also still closely monitoring their cash and the risks to cash flows. This includes evaluating business practices to optimize working capital levels needed to support the business and releasing any excess cash that could be used for other purposes, along with enhanced cash-flow forecasting. Working capital entered the top ten themes for the first time in Q3.
Our analysis also shows that more companies are thinking about structural changes to their portfolios to position themselves for the longer-term. Mega-deals aside, we’re still waiting for the swath of consolidation we’d expect in this environment. One thing that seems to be holding up this process is valuations. Broadly speaking, companies aren’t dropping the valuation on their own assets to match the current oil price environment, but they expect sellers to do so! When the sector moves past this impasse, reaches a consensus that prices aren’t going to rise significantly from here and value according, we expect more deals to flow through. Our latest Capital Confidence Barometer certainly shows an increased appetite for deals.
Down the supply chain
Change won’t come evenly. One of the most notable features of the last few years is now much pressure has been felt down the supply chain and it might be here where pain lingers the longest. Our latest review of UK Oilfield Services shows that revenues in the UK supply chain look set to fall by 21% in 2016 after falling by 10% in 2015, taking total revenue below £30b for the first time since 2000.
The sector has experiences some notable failures, but overall has held up better than expected due to the actions of companies to cut costs and the support of funders. It will be hoping that it’s finally be approaching the nadir, but capex will remain constrained and intense competition, low utilization, and poor pricing won’t disappear overnight.
We asked back in February if oil could be too cheap, concluding that it could be, if the price fell to the point of creating instability, whilst only providing a marginal boost to growth. The price has recovered significantly since, but remains well below average, which should provide sector stability without upsetting growth – albeit with some local distinctions. The price rise will feed into inflation, which is part of the trend that is pulling investors out of sovereign bonds and towards equities. It could be a significant factor in UK inflation in 2017 given the continued weakness of the pound against the ever mightier dollar. But there are many moving parts – something we’ll explore next week.