Saturday, 14 March 2020

What Low Oil Price Environment Means to Investing?

It has been one week since the Saudi and Russia disagreed in their production cuts. The week long price movement in WTI Crude and Brent gives an indication of where prices will be in the year or so.

To me, it seems WTI will trade in the band of US$30-40, while Brent will trade in the band of US$35-$45. It is at this junction one will wonder how they can position themselves in their oil investments

Four Main Ways to Extract Oil

There are 4 ways to extract way: I) Onshore (land) drilling, ii) Extracting Oil from shallow Water wells (less than 150 metres), iii) Deep water oil wells and iv) Shale Oil.

Each method has their own breakeven cost. Onshore land drilling is the cheapest where the Saudis are extracting oil at a single digit per barrel, the Russians are extracting oil in the USD$10-$20 range. This means at current levels, it is still cashflow positive for many onshore drillers to extract oil. Do note, I am looking at the cost of extracting oil, there are other cost items to look out for such as corporate overheads etc which is why there are news that says "Russia need $40 oil per barrel to break even/balance their budget" etc.

For me I am looking at purely the cost of extracting oil which will affect the immediate businesses supplying to the 4 different oil extraction Segments. Their is another cost analysis people look at which is the total breakeven cost, this affects their decision to intiate a new oil well or otherwise. For shallow water, deep water and shale, such breakeven cost tend to be US$50-US$70 per barrel. This means it is unlikely we will see new oil projects coming in.

How much it cost for Shallow Water Drillers and others?

Moving on, the cost of extracting shallow oil is unknown to many of us; fortunately, there is one listed Shallow Water Oil Producer company here- Krisenergy. Based on their corporate presentations, the cost of extracting oil ("Lifting cost:) in South East Asia shallow waters is US$20-25; it means shallow water oil operations is still cash flow profitable under current circumstances.

Deep Water drilling cost is about US$25-40, while Shale is US$25-60, the US Permian basin has one of the cheapest extraction for shale oil but its the only one, the rest are in the range of US$30-50s.

Seen in this light, at current oil prices, it is definite shale oil is not profitable to extract and companies will not be adding new shale oil wells (Shale oil companies need about US$50-60 to justify drilling new shale wells). My view is that Shale Oil will fail in the next 2 years.

How it Affects SGX Companies

There are only a handful of companies that has exposure to shale such as CSE Global. At current low oil prices, CSE is going to see a fall in revenue especially when the US segment is one of its largest revenue.

The other SGX companies tend to service the shallow oil producers. Examples are Nam Cheong, Penguin Holdings, Marco Polo Marine, MTQ (MTQ services companies across the 4 extraction segments). While shallow water oil producers extract oil at a much lower cost, the lower oil prices will affect their revenue and they will try to ask for lower quotations from the mentioned companies for the services they provide.

Sembcorp Marine and Keppel Corp services the deep water and shallow oil segment where the profitable contracts tend to be deep water oil rigs. It is likely with such low oil prices, Sembcorp Marine and Keppel will see very little new orders. They will have to rely on refurbishing ships to sustain their yard operations.

However as we progress through this oil crisis, it is likely shallow oil producers will emerge from the woods first. This is due to their lower cost base

My rough gauge is that Shallow Oil needs US$50-US$55 per barrel to breakeven from all costs they have.  

How Long will the Oil Price War Continue?

In my opinion, this can go on for a long time. Saudi Arabia and Russia carry very little debts. So if they continue to sell oil at below their budget breakeven, they can resort to taking on more debts at cheap rates. They have to be thankful for the QE by the 3 main reserve banks (US Fed, ECB, Bank of Japan).

Shale oil producers will not last long because they are already in a state where they have taken a lot of debt and are struggling to repay their debts even at these low interest rates. Russia and Saudi Arabia can move to the phase of taking more debts and with their low oil extraction rates, they can easily service the low interest on their newly issued debts.

In 2021 and 2022, we will likely see shale oil being almost wiped out and at that junction, I believe Oil will then move on to $40-50 range. I do not think Oil will go back to above US$70 for a long time because this makes it profitable to drill new shale oil wells. 

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