The rebound in oil prices that started way back at the beginning of 2016, finally ran out of steam a couple of months ago when prices hit a four year peak just shy of $87 a barrel in October with many forecasts predicting a move towards $100 a barrel.
The main driver behind the summer move above $72 a barrel, and then $80 was the unilateral US decision to reimpose sanctions on Iran for what US President Trump called its “threatening and destabilising behaviour” in an attempt to redraft the nuclear deal which he described as the “worst deal ever”
The controversial move which invited a storm of criticism from US allies did prompt the US administration to delay the implementation of the sanctions with a deadline of 3rd November for countries to comply with the order not to do business with the Iranian regime, where output was estimated at about 3m barrels a day.
In an attempt to mitigate the damage and stem the upward move in prices the US President ramped up pressure on OPEC to increase production to compensate for the loss of Iranian output.
As a result OPEC was able to produce 32.9m barrels in October, while non OPEC members managed to produce 18.25m barrels. US output also rose to in excess of 7m barrels a day, a record, and while the Khashoggi affair did prompt concerns that Saudi might weaponise its position as a swing producer, such a move would have destroyed any credibility it might have as a stable actor.
Such a move would in all probability destabilised the oil market, as well as raising the prospect of a global recession if prices did spike up to $100 a barrel and would not have been well received by its peers, who rely on sustaining the balance of supply and demand so as not to slow the global economy and kill demand.
As it is there has already been rising evidence of a global slowdown in demand as inventory build ups have risen. US inventories showed early signs of that at through October and November with consistently above expectation rises, averaging over 5m barrels a week.
This build-up in inventory levels at precisely the time that oil prices pushed above their May peaks appears to have also coincided in a slowdown in economic activity levels. While some have blamed concerns about trade war escalations, and the imposition of tariffs, it also can’t be a coincidence that, as can be seen from the chart below, the move through the summer peaks, which pushed the rise in oil prices this year through the 15% level, probably also helped prompt a Q3 slowdown in demand.
Unsurprisingly the sharp decline in oil prices has also hit the share prices of the main oil companies which have spent most of this year underperforming relative to the wider benchmark, despite posting rising revenues and profits, as they benefit from higher margins in both downstream and upstream businesses.
Both Royal Dutch Shell and BP have disappointed this year, though the performance over a two year period is slightly more positive they still aren’t ripping up any trees.
On a two year time horizon both Shell and BP are just about in the black but its single digits in pure percentage terms, though that doesn’t include reinvested dividends.
Source: CMC Markets
At its last set of results, for Q3 Shell showed recorded it’s best ever level of cash flow while returning its highest level of profits for four years.
Higher oil and gas prices helped boost margins in the first part of the year, while the company has also been buying back its shares as it looks to boost shareholder returns after its purchase of BG Group.
The biggest concern would appear to be around declining natural gas production which the company said it expected to remain subdued, in the short term, though it is expected to improve in the longer term. The recent sharp fall in oil prices might crimp its oil based revenues for Q4, which may help explain some of the underperformance, but overall as long as oil prices don’t fall off a cliff it is hard to see too much in the way of downside.
BP shares also underperformed relative to the oil price when it was rising, and could well struggle to finish the year in positive territory. Unlike Shell they do have the legacy of the 2010 Deepwater Horizon Gulf oil spill hanging over them, though on the plus side additional provisions are now much less than they were a few years ago.
The shares also managed to hit their highest levels since 2010 earlier this year touching 600p before briefly slipping back. In October the company reported its highest quarterly refining ability in 15 years, while also beating profit expectations for its Q3. Its net profit came in at $3.8bn, well above expectations of $3bn, while profit for the year to date was $9.2bn, well over the $4bn for the same period a year ago.
The boost to profits came about as a result of the early delivery of expansion projects in the Gulf of Mexico and Australia, which boosted overall output.
The $10bn acquisition from BHP for its US shale assets is expected to complete by the end of this month with the entire transaction expected to be funded by the proceeds of cash generation, assuming oil prices had remained at their summer levels.
The subsequent decline in oil prices since October has blown a hole in that calculation forcing BP to launch a sale of $3bn worth of US onshore oil and gas assets, to fill the hole created by a 30% decline in oil prices, and in so doing raises further questions about the company’s ability to continue reducing the level of its debt.
Net debt still remains quite high at $39.2bn,but it is lower from a year ago when it was $39.8bn, putting its debt gearing at 27.5%. The company said it still remains on course to meet its 2018 divestment target of $3bn, which it says it will use to reduce its net debt figure further, while at the same time keeping its gearing ratio between 20-30%.
The company was more cautious on the remainder of the year, saying it expected production to be higher than Q3 with the integration of BHP, but for margins to be slightly lower. The wider worry remains its debt levels given the recent sharp selloff in the oil price, which is likely to have hit its margins in the current quarter, while the rise in US rates in the last 12 months won’t have helped in terms of its debt costs.
The biggest problems the companies are set to face is the move away from oil consumption towards renewables and biofuels as measures to deal with climate change become more mainstream.
With the Norway sovereign wealth fund announcing it would be pulling back from investing in oil and gas assets in the coming years the big task for oil companies in the coming years will be to reduce their reliance on their traditional means of income and invest in renewables like wind and solar energy.
BP is already leaning in this direction after investing $200m in Europe’s largest solar power provider, Lightsource,which is developing solar projects in Asia the US and Europe. This project appears to be going in the right direction with new contracts being signed across the US this year, in California and New Mexico, as well as Brazil.
The company BP Lightsource has also announced its intention to use thousands of solar panels near Sedgefield County Durham to power 13k homes in the North East of England.
Royal Dutch Shell appears to be leaning in a slightly different direction after it agreed to buy NewMotion, an electric vehicle charging company last year, in an attempt to roll out charging point technology to its forecourts.
The company is also investing in other alternative fuels including liquefied petroleum gas and hydrogen on top of its $50bn investment in liquefied natural gas when it bought BG Group in 2015.
As we look ahead to 2019 and the prospect for the UK’s two biggest dividend payers the outlook continues to look positive despite the shares of both being close to multi year highs.
Whether or not we see further gains will largely depend on firstly whether the current levels seen in the oil price so far this year are sustained, but also in how successful both companies are in diversifying away from their traditional business models.
Both have made decent progress in terms of their gas businesses and in cutting costs but more progress needs to be made, with gas making up about 50% of BP’s business now.
The biggest concern remains around BP, in that its high debt levels and wafer thin dividend cover still make it vulnerable to an economic slowdown or a drop in demand. In its favour, breakeven costs are lower than a year ago, but a sustained move below $50 a barrel, would raise further concerns, about the company’s ability to increase returns to shareholders.
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