The Current Slump in the Oil & Gas Industry

When I joined my current oil company back just last year in August 2014, oil prices was trading slightly above $100 per barrel.* The oil and gas sector in Singapore back then was running at full steam, coming from a strong year in 2014 for the "black gold" related businesses. Analysts were expecting 2015 to be no different, some even predicting this year to be stronger for the oil sector.

*Refers to brent crude oil prices

What actually happened was a rude awakening to everyone's expectations. Oil prices plunged to less than half of its value back in mid 2014, to a low of $45 per barrel in early 2015. It has since recovered somewhat, stabilising at around the $60 per barrel region, leading to some analysts to believe that we have seen the worst in oil prices, and that the bottom has passed. Well, oil prices is one thing, but the current situation in the oil industry remains as bleak as when the oil prices plunged back then. I can say this for sure because I am working in the industry, and being at the frontline in this industry has allowed my to form my own views about the future of this industry against the more optimistic analysts.

Oil companies are still cutting back aggressively on costs and spending, particularly capex, short for capital expenditure on new investments in oil assets. The focus right now is on keeping and maintaining the existing assets for a long as they can function. This would affect many companies like Singapore-listed Keppel Corp and Sembcorp Marine, largely because this companies require new orders to maintain their income streams. They do not own oil assets or drill for oil, they service the oil majors with assets like rigs and ships. Primarily, we can view them as manufacturers of such assets, and this is currently a potentially a weakness because they rely on the spending by oil majors to acquire new rigs or ships. With them cutting back on spending aggressively, it doesn't take a genius to know what would happen next. The current supply glut of rigs are not helping, as well as intensified competition from smaller rig builders in Korea and China.

How about if when oil prices do recover strongly back to the $100 per barrel level? First of all, I want to point out that this may take a long time to happen, because the current low oil price situation is a supply-side driven phenomenon, unlike the previous crises of 2008-09 global financial crisis (GFC), or the 1998 asian financial crisis (AFC). Those crises were demand-side driven price plunges because of the plunging demand from consumers. The current situation is different because the issue comes from the heavily increased production of oil, not just from the US shale production which OPEC blames, but OPEC themselves not willing to cut back on production, preferring to produce more to protect their market share. This lead to price plunges not seen since the 1980s. 

Perhaps lets rewind ourselves back to what happened in the oil glut of the 1980s.

If we look at the chart above, oil prices plunged in 1985-86 due to a global glut in oil supplies partially due to slowed industrial activities in major countries. Because of the previously high oil prices in early 1980s ($30 per barrel then was $100 per barrel today), there was over production of oil from non-OPEC countries. The supply glut had actually happened in the early 1980s, with the Soviet Union becoming the largest producer of oil and the US relaxing its controls over its own oil production. This surge in production caused prices to slip, and OPEC responded by cutting production to maintain high prices. This did not work as the reduced production was simply taken over by non-OPEC and OPEC countries who cheated the Saudis. The Saudis were not a very happy group when they found out some of its OPEC members were cheating, so they punished them by producing at full capacity. Oil prices plunged when that happened to as low as $7 per barrel.

US Marines walk past a burning oil well in Kuwait

In terms of price recovery, it did happen, though temporarily during the Gulf War in the 1990s. A sharp spike in the chart temporarily jacked up the price of oil back to the pre-1980s glut era, but fell back down just as quickly when the war ended. Sustained price recovery only came a good 15 years after the plunge in prices.

So if you think this is going to be a simple V-shaped recovery for oil prices, think again. Though I believe that prices would most likely recover earlier than 15 years it took back in 1980s, because the still strong demand from India and China will likely absorb the higher supplies of oil. Once the oil industry finds its footing, and when the market realises that the demand is still very much intact and even growing, prices should recover, likely in a slow sustained manner. The lack of capex spending on new assets also would result in less oil producing assets, which in turn result in demand outstripping supply in future. This is what is going to happen eventually, but the question we should be asking is when, not what will happen.

So, what I am trying to say is that oil demand is here to stay, and while the oil glut may cause reduced prices, going long term on fundamentally strong oil companies is a sound strategy. Keppel Corp or Sembcorp Marine? Well the choice is yours to make, but I have an advice to those who are interested. Both are oil service companies, so basically they will feel the pain much earlier due to rapid capex cuts, and will only enjoy the benefits of the recovery much later than when prices recover when oil majors realise that the industry has recovered before kick starting the capex spending again. In addition, we buy shares as low as possible, so what we do not know is whether the market has priced Keppel Corp and Sembcorp at weakened earnings, as we have yet to see earnings weaken. The large order book created in the pre-glut years is keeping them busy with income streams in the meantime. 

So if you would ask me, I would prefer to wait it out first because the prices may face more downside if cancellations or postponements of the orders are made. Besides, I am already accumulating my own company's shares as part of the employee stock plan, so that should be enough of an exposure to the oil industry for now.

What do you guys think?