Relief at the gas pump is not bringing joy to everyone. For the companies involved in the energy sector, the rapid plunge in crude oil prices over the past few months (from $100 a barrel of West Texas crude to a recent $82) has led to concerns of a prolonged industry slump. What’s causing the industry headaches?
Too much supply (coming from the U.S. and OPEC) and not enough global demand. Those factors had been in equilibrium until a clear state of oversupply began to emerge in storage depots in recent weeks. With U.S. oil production already at a 28-year high and continuing to grow, and OPEC showing little willingness to cut supply in response, concerns have arisen that the price slump may only deepen.
Without a sense of when oil prices will bottom out, share prices of many oil services providers, along with those of exploration and production (E&P) firms have fallen 25 percent or more over the past few months. The good news: Oil prices are not likely to head much lower, and may be making a bottom right now.
While it’s hard to spot reasons for optimism, remember that falling prices can act as a corrective market mechanism. “It’s hard to see how oil can remain below the marginal cost of supply, which is $90 a barrel,” says David Meats, an E&P analyst at Morningstar. He figures budget cutbacks on new oil wells will bring supply down, perhaps right a time when demand rebounds. The International Energy Administration (IEA) predicts that global demand for oil will rise by 1.1 million barrels in 2015. Another potential positive catalyst: OPEC ministers will be meeting again in November, at which time they may finally look to make a coordinated cut in output.
To be sure, the recent drop in oil prices may lead to a reduced demand for services and equipment at both onshore and offshore oil fields. The Market Vectors Oil Services ETF (OIH) appears to anticipate tougher days ahead, having fallen more than 20 percent over the past three months. “This leaves the (oil services) sector trading at levels not seen since late 2005 (with the exception of 2009), before the beginning of the previous cycle,” wrote Barclays’ Lydia Rainforth in an October 14 note to clients. She notes companies such as Schlumberger and Halliburton, leading components of that ETF, still have a considerable amount of backlog to work through before they would start to feel the impact of industry cutbacks. The Market Vectors ETF carries a reasonable 0.35 percent expense ratio.
The Market Vectors ETF, along with the iShares Dow Jones US Oil Equipment Index RTF (IEZ) (which carries a 0.45 annual expense ratio) are both squarely focused on the biggest oil service providers, thanks to their market cap-weighted approach. The SPDR S&P Oil & Gas Equipment & Services XES ETF (with a 0.35 expense ratio) takes a different approach, owning an equal weighting in 50 global oil services firms. That approach could prove riskier if the industry’s top players seek to take advantage of current industry conditions by aggressively pricing their services in order to steal market share. You can already see evidence of such concerns by looking at shares of mid-tier player McDermott International, which have lost nearly half of their value in the past three months.
Even greater opportunities may lie among the E&P ETFs. After a precipitous slide, “the oil-levered E&Ps are already pricing in long-term prices below $70/barrel,” wrote analysts at Credit Suisse in a note to clients. Note that oil prices are still more than $10 above that level. These analysts add that they “continue to see upside (for industry shares) at $70/barrel (for West Texas crude), not to mention the substantial upside seen at $90 a barrel.”