OIL…….Something Happened

OIL…….Something Happened

7 Jan 2015

The recent sharp fall in the price of crude oil is one of those rare financial events whose importance is appropriately reflected in press headlines.  Oil has a strong claim to be the world’s most important commodity and also the most political. OPEC was founded in 1960 by the charming quintet of Iraq, Iran, Saudi Arabia, Kuwait and Venezuela. According to its website:

“OPEC’s objective is to co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry.”

Were these companies rather than sovereign nations, this would be an illegal price rigging cartel subject to enough lawsuits to employ every lawyer until the end of time. As it is, it’s a legal price rigging cartel that everyone else has to live with if they wish to continue consuming oil. In 1973, OPEC became explicitly political when the US supported Israel in the Arab-Israeli war. It banned exports to the US and the barrel price of crude quadrupled from $3 to $12. It was a shocking inflationary impact that the world did not need. The Iranian revolution in 1979 saw a further leap from $14 to $40. The next great move came in the 21st century as global economic growth was propelled by developing countries such as China and India that became huge importers of oil. The price touched $140 until the financial crisis torpedoed the world economy in 2008 and the price fell right back to the 1979 price of $40.

It is worth making a couple of points here. One is that the oil price has shown itself to be very volatile with changes in marginal demand having a huge impact. The other is that, partly thanks to OPEC, the market’s opinion of whether oil is cheap or expensive has largely relied on referencing its own history – the most unsophisticated way of valuing anything.

That having been said, it is obvious that oil over $100 makes costly oil supply viable, notably from Canadian oil sands but also from fracking. The world would have extensive sources of oil and countries like the US could achieve a long-held ambition to free themselves of reliance on OPEC. But at today’s price of $50, a vast amount of actual and intended investment in new production is likely to be abandoned. Moreover, the alternative green energy industry also receives a body blow because the opportunity cost of switching from fossil fuels jumps sharply.

Largely thanks to OPEC, most analysis of the oil price focuses on supply. Developed countries have for years treated the consumption of oil as a regrettable necessity with rising prices inflicting unavoidable cost increases. Around ten years ago, oil consumption in the US and the EU (measured in barrels) started to fall, encouraged by environmental efforts and other technology changes. Some improvements in manufacturing practices (robotics, for instance) allow the reintroduction of local production thereby cutting the need for the international transportation of raw materials and finished goods. By contrast, the oil consumption of developing nations has risen consistently. The net result has been that overall global oil consumption has been rising gently.

As I write, the world is wondering whether world oil demand is starting to fall, in response to the economic woes that are implied by global bond markets.  It may well be the case that supply, excited by $100+ a barrel, was ramped up too high. But $50 oil should gradually take care of this, both by curbing production and stimulating marginal demand.

Traditionally, Saudi Arabia has acted as the key OPEC supplier, leading output cuts when it wanted to firm up the oil price and releasing extra barrels when its customers were getting squeezed too much. Recently it has stated that it will not cut output to support prices. It wants to retain market share. Most commentators believe that Saudi Arabia can stand lower prices for longer than other major producers.

Some people interpret this as an attempt to curb investment in shale gas, oil sands and alternative energy sources. Others see it as a direct blow to the oil revenues of rogue states including some that support terrorist groups. Whatever the motivation, these are all probable outcomes.

At present, stock markets are being dragged down by the companies that are likely to be hurt by weak oil. These include oil producers, producers of alternative energy sources, suppliers to oil producers and explorers, companies that sell anything to major oil exporting countries (e.g. Russia) and banks that have funded any of the above. Stock markets are not yet being lifted by companies that can be expected to benefit from cheaper oil. These include airlines (their shares have been strong, in fact) and other transport-related sectors such as auto producers, aeroplane makers, train and bus companies plus companies that sell to any of the above and consumer shares in general (because lower fuel prices are effectively tax cuts for households).   

So how do we play this as investors? The first thing to say is that a shocking halving in price of such an important commodity is likely to have effects that do not reverse quickly. The financial plans of some major companies will have been obliterated. If the likes of BP and Royal Dutch Shell do not cut their dividends they will probably have to borrow to pay them. This is obviously unsustainable and a decision to maintain their dividends would imply that operating cash flow will recover in a year or two. To take that view would be little better than a gamble in my opinion. The companies will also have to decide by how much they dare cut capital expenditure. Play these for a share price bounce if you wish but be aware that fire sale prices could be way below where you can imagine.

I am naturally tempted by the shares of the perceived beneficiaries from cheaper oil, though I expect the benefits to take some time to feed through (in a kind of J-curve effect). I looked at the announced fuel hedging policies of the four UK-listed transport companies, FirstGroup, Go-Ahead, National Express and Stagecoach.

Stagecoach is 94% hedged in the current year and then 78% in year two and just 6% in year three. Compared to its peers, this makes it highly geared to the falling oil price. National Express is 100% hedged for two years and 94% for year three. FirstGroup is 87%, 78% and 30% respectively and Go-Ahead is 100% hedged up to fiscal 2018! My enthusiasm for Go-Ahead has cooled, though mostly because its shares have risen so much. I own some National Express because it has substantially repaired its balance sheet and its shares offer a FCF yield of 9% based on 2013 cash flow.

In November Ryanair said that it had hedged 90% of its fuel requirements for the year to March 2016 at the equivalent of $93 a barrel. Once again, a real windfall is deferred. Easyjet is more geared: in November it had hedged 58% of its fuel needs for the year to September 2016.

Here are a couple of shares that are well off their highs, are financially solid and might benefit from lower oil.

Presumably airlines will now be happier to order new planes. This makes a prima facie case for the shares of Rolls Royce (862p) which are down by 33% from their peak a year ago following warnings and restructuring costs in respect of its defence and marine businesses. It has recently sold it gas turbine business to Siemens. This has the feeling of a good trade. In the last half year, civil aerospace was 47% of revenues and 63% of underlying profit.

Another off-the-wall idea is the much derided political plaything called Royal Mail (419p). It seems financially very sound, having had its pension liabilities generously sorted out by the UK taxpayer pre-privatisation and having started to receive planning permission to develop its central London properties. On Christmas Eve, City Link, a rival deliverer of parcels went bust after years of struggle. It is a very competitive market but the hard truth is that it is good news for the rest when a rival falls.

Although wages are by far the most important cost factor for the group it is also effectively a transport business. From the last annual report: “UKPIL (UK Parcels, International & Letters) is exposed to fuel price risk arising from operating one of the largest vehicle fleets in Europe, which consumes over 130 million litres of fuel per year, and a jet fuel price risk arising from the purchasing of air freight services.” There is no mention of fuel hedging in the annual report. Were fuel prices to fall by 20p a litre, it would theoretically save RM more than £26 million in operating costs. That’s 6% of 2014 operating profits and would pro rata raise its operating margin from 4.5% to 4.8%. It’s not a fortune but it would be very helpful for a share that is more than 30% off its high in the last year. 

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