I know I know, oil and gas industry hasn’t been doing well for the past few years. Although the Organization of Petroleum Exporting Countries (OPEC) vowed to keep the price of oil above $100 a barrel for the foreseeable future, but in mid-2014, the price of oil began to tumble. It fell from a peak of above $100 a barrel to below $50 a barrel. So why am I talking about Oil and Gas Industry Outlook 2017, when the industry is still in crisis? It’s exactly because the crisis is not over yet, many good companies are traded at a cheap price, making it the best time to buy. For value investors like us, crisis is our best friends. 😉
Oil and Gas Industry Overview
Oil is a commodity and OPEC is the main influencer of fluctuations in oil prices. OPEC is a consortium made up of 13 countries: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela.
OPEC controls 40% of the world’s supply of oil. The consortium sets production levels to meet global demand and can influence the price of oil and gas by increasing or decreasing production. When oil is over-supplied, yet OPEC refuses to cut production, it will cause the tumble in oil prices.
Oil and Gas Industry Structure
The oil and gas industry is usually divided into 3 major sectors: upstream, midstream and downstream.
The upstream sector includes searching for potential underground or underwater crude oil and natural gas fields, drilling exploratory wells, and subsequently drilling and operating the wells that recover and bring the crude oil and/or raw natural gas to the surface.
The book “Why Moats Matter” by Morning Star gives an in-depth discussion of different companies under the Oil and Gas industry. Below is the key summary extracted from the book. If you want to find out more about O&G and other industries, and truly understand the necessary analysis to identify a good company, I highly recommend you to get this book. Amazon now give a 35% discount.
Oil & Gas Drillers
Oil and gas drillers which provide rigs, crews, and the associated drilling services to oil and gas firms on a day-rate contract basis, generally do not have moats. Drillers operate in a very tough environment where price drives decision making among customers, although intangibles such as quality of service, operational and technical expertise, equipment suitability and availability, safety record are also considered.
Demand for drilling rigs depends on customer expectations around commodity prices in the near future and the expected economics of their projects. Given the different demand and supply drivers, there are frequent mismatches between supply and demand, resulting in a highly cyclical industry, where day rates can swing more than 50% during a cycle.
In this competitive environment, the largest offshore drillers enjoy substantial competitive advantages over their smaller peers, but very limited or no advantages over their closest major peers. Larger rig fleets provide major offshore drillers with several intangible assets, including financial stability throughout the decades-long project cycle, the ability to match an experience crew with a new rig, and more rig options to meet a customer’s requirements, as well as strong reputation and an excellent safety record. Replicating this type of expertise is difficult, as it can take several years and up to $750 million to construct an ultra-deep-water rig, and experienced engineers are in short supply.
Transocean (stock code: RIG) for example, has achieved a narrow moat thanks to its specialization in ultra-deep-water drilling. It owns twice the number of deep-water rigs as its closest peer and is by far the most experience deep-water driller.
Oil & Gas Exploration and Production
They are firms that possess the rights to harvest commodity from geological deposits. Cost advantage is the main potential moat for E&P companies. Because these companies are producing undifferentiated commodities, the ability to produce at a cost well below the prevailing price is the only real option for generating economic profits. The only potential candidates for wide-moat ratings would be low-cost producers with long reserve lives, where production levels can be maintained based on current reserve for decades to come.
The midstream sector involves the transportation (by pipeline, rail, barge, oil tanker or truck), storage, and wholesale marketing of crude or refined petroleum products.
There are multiple ways for midstream companies to build moats, but efficient scale is the dominant source. Once a pipeline is in service, it typically enjoys excess returns. Midstream firm typically seek to lock in project through long-term contracts with shippers before ever breaking ground on a new project, ensuring that project and capital costs are recouped, with potential for excess returns over time.
The downstream sector commonly refers to the refining of petroleum crude oil and the processing and purifying of raw natural gas, as well as the marketing and distribution of products derived from crude oil and natural gas. The downstream sector reaches consumers through products such as gasoline or petrol, diesel oil, liquefied petroleum gas (LPG) as well as hundreds of petrochemicals.
With no differentiation among products, accessing to discounted crude becomes the most valuable competitive edge a refiner can have. This advantage comes in 2 forms. One is proximity to crude production or access to stranded crude that allows the refiner to enjoy a discount. The other is a refiner’s ability to process low quality, heavy crude with high complexity, to light and sweet crude.
Valero has created a narrow moat with its 14 refineries. Its system is more complex than competitors which allows the firm to process lower quality feedstock into a high value product. Valero can take advantage of the discount at which these crudes typically trade compared with light crude.
Oil and Gas Industry Outlook 2017
Despite hope offered by the biggest oil deal in a decade and a new pro-fossil fuel administration in the White House, it’s unlikely that oil price will re-bounce quickly in 2017.
Last November, OPEC reached an agreement to cut output by 1.2 million barrels a day to no more than 32.5 million barrels a day and other non-OPEC countries pledged cut production by nearly 600,000 barrels more.
Once the announcement was made, oil prices started to take some gains. But according to NASDAQ, the recent uptick in U.S. shale production has put more pressure into the market. In other words, while OPEC’s moves to trim output and re-balance the demand-supply situation has stabilized the market to a large extent, in the process it has incentivized shale drillers to churn out more.
To sum it up, oil’s future direction will depend on the battle between the OPEC-led output cuts and the increase in U.S. shale production.
Moreover, Goldman Sachs warns that another downturn could come over the next three years, sparked by a new wave of supply stemming from mega-projects planned years ago. According to Business Insider, these projects cost billions of dollars and take many years to bring online, and many of them were initiated back when oil prices traded at $100 per barrel.
Goldman identified a handful of projects in Brazil, Russia, Canada and the Gulf of Mexico that will reach completion and add to global supply between 2017 and 2019. Combined with new shale output, these projects could add another 1 million barrels per day next year.
Oil and Gas Industry Outlook 2017 – So Should I Buy O&G Companies?
As you can see, the market sentiment is generally negative. Many people expect the oil price to remain low, with some even expect it to plummet further. But as a value investor, it actually provides a great opportunity to buy into good oil and gas companies at a cheap price. Many companies are undervalued right now. If you adopt a long-term investing approach, the period is indeed the best time to go in.
In Short, Investor Must:
- Better to get in oil and gas at a cyclical low.
- Keep a close look at OPEC and determine its strength in controlling the market prices.
- Economies of scale are the only way to achieve a competitive advantage. As such, bigger is generally better.
- Look for companies with low debt (D/E <1) to make sure the company has the capability to tie through this crisis.
- Read more books to gain better insights into different industries. As mentioned, Why Moats Matter by Morningstar is a great book which delve deep into various industries, not just oil & gas.
- Another book that I also highly recommend is The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market. This book also delves into different industries and give a quantitative analysis into each sector, while Why Moats Matter adopts a more qualitative approach. Both books are having promotions right now. Grab this chance to get both if you are serious about learning!
Last but not least, I also wrote another article on the recent FED rate hike, which talks about its impact on investing and travel, if you want to find out more, check out my blog post here. Happy reading!
Stock recommendations and comments presented here do not represent my opinions on whether to buy, sell or hold shares of a particular stock. All investors are advised to conduct their own independent research into individual stocks before making a purchase decision.