The Oil Story Continued : Where Is The Pain ?

The beautiful and wonder of owning a natural resource is that it will always be yours, unless it is perishable.

And the beauty of owning a non renewable form of natural resource is that eventually demand will return. Whilst I have always personally felt that there is some injustice in having all the diamonds and coal etc., in the world owned by a few large corporations or states, there is no other way about it under the current global economic structure.

Thus it should not be a surprise that the large resource companies will bear the least brunt from the “supply shock” 25% drop in oil prices this year.

That is not to say that the smaller and less established companies will not suffer because 1. they do not hedge their prices ahead and sell in the spot market, 2. they do not have the economies of scale in operation, 3. they do not have diversified cashflows and, 4. newer companies are usually more highly leveraged and run on negative cashflows to maximise their returns.

This is applicable to all the companies in the oil supply chain and the biggest risk has yet to bite them which has been their happy go lucky and trigger happy OVER INVESTMENTS in the past 2-3 years.

oil supply chain

THE OIL SUPPLY CHAIN (SOURCE : DNB)

 

DNB, the biggest bank from the second happiest country in the world, estimates that a sustained price of Brent below $83 would trigger a 10% reduction in spending or CAPEX.

Additionally, it has been observed that oil companies have over invested in capacity and distributed too much back to shareholders. Thus, they technically need oil at $ 130 to balance their budgets.

CAPEX spending has rocketed 26% in the past 12 months compared to the historical average of 17%.  This comes at the price of heavy leverage which extends down the supply chain.

If anyone would be hit, it should be the folks down there in the supply chain once the companies cut back their discretionary spending and just focus on pumping from their current wells which would greatly reduce their costs for the time being.

Yet, CAPEX spending works backwards. Rigs, drills, ships and bits are made to order years ago and are due for delivery at a later date. The orders made in 2013/2014 will only be due for delivery sometime between 2015-2017.

These companies taking the orders have the risk of non delivery or delivery push backs which will hit their profits hard.

The offshore rig segment is the most capital intensive segment in the chain and here is what the orders look like.

offshore rig deliveries

Source : DNB

 

We note in our previous post that the offshore  oil supply is one of the most expensive ones to extract. https://tradehaven.net/market/the-oil-story-to-2020-and-beyond/

COST OF OIL PRODUCTION

Industry averages are slightly delusionary because we have the heavyweights evening out the averages making the situation look a tad more bearable than reality.

The truth is that small and highly leveraged companies are most at risk. These companies rely on a handful of contracts from various parties and employ expensive financing (through bonds) to get the work done before they get paid.

I cannot disagree with the DNB conclusion that it is unlikely that a vast majority of the bond issuers will default. But their outlook is nonetheless veiled in pessimism.

Refinancing risk is a main issue besides the sporadic defaults we shall see in the coming months.

Yes. Defaults don’t happen the day of the oil price crashes. It comes in waves much later which is inevitable.

Warning signs aplenty as evidenced in the sudden drying up of bond market activity in the heavily oil associated NOK corporate bond market.

It is evident here in Singapore too, noting that Loyz Energy seemingly failed to get their bond issue off the ground. (Note that they are in small time exploration and extraction)

The mentality is why buy now when it will come cheaper. And price discovery has become non existent because the market does not know where the fair level is.

Not the same mentality for stocks where the mood has turned to DUMP fest especially for the small and medium sized companies.

Dividends and earnings risk make equity investments in these little names a little imprudent unless more thorough research has been done. Bonds should be safe at a decent discount and it is recommended you follow these rules when assessing the companies.

  1. Solid counterparties for contracts.
  2. Healthy balance sheets with little funding needs or access to several sources of funds eg. bank lines, shareholders etc
  3. Mid to late cycle exposure ie. lower down the supply chain and not in the high risk exploration work business.
  4. Tightly structured loan agreements and strong security packages.

Now we all know why they have been unloading so many new issues into the marketplace here.

And a brief glance at the coupons and prices, I am guessing that investors are not being compensated enough for the risks ahead.

The Singapore context is slightly different from Norway because that market has experienced a hit before back in 2008 when oil prices tumbled to a low of $32.40 in Dec.

Back then, the Singapore corporate bond market was spared because there were not too many O&G issuers then thus Singapore is relatively green horn compared to them.

But I am not in the business of spreading fear so hang on to your horses, especially if your bankers have told you that everything is alright.

Yet, it would be wise to heed that the Over Investment theme is not just limited to the oil business. The number of leveraged buy outs in virtually all sectors including the real estate market has been alarmingly high.

Most people would take a look at the record highs in the S&P, Nikkei and rest, and tell me that I would be mistaken if I think that Over Investment is a problem.

My reply would be to see if BoJ or the ECB will be there to give Swiber, Oxley, Aspial and gang a loan one day.