Things don’t appear to be getting much better in the energy sector.
Bloomberg reported last week that:
‘Woodside Petroleum Ltd. and partners including Royal Dutch Shell Plc scrapped plans to develop the $40 billion Browse liquefied natural gas project in Australia after the plunge in oil and gas prices.’
You don’t have to be much of a technical analyst to understand why. Just check out the chart below of natural gas prices going back to 2006:
The natural gas price is down 86% since the 2008 peak.
Natural gas was the hot topic back in 2008, and even through most of 2010. I remember it well. As editor of the Australian Small-Cap Investigator service back then, I recommended a number of natural gas plays.
Most of them played out well. The standout performer was Bow Energy, which clocked up a 458% gain by the time I recommended selling it.
But the situation playing out in the natural gas market now shows you what happens when prices get out of whack.
The natural gas price soared in 2008. Investors and energy companies saw this as their perfect chance to make a killing in the sector.
This drew hundreds of companies into the market. They each wanted a slice of the action. Companies fell over themselves to be the next to acquire…or, at the very least, to be acquired…
Take Bow Energy as an example. It was a tiny natural gas explorer in Queensland when I recommended it in December 2008. As I recall, its market capitalisation was somewhere around $20 million.
By the time it was taken over in 2012, the company was valued at $420 million.
The company that took over Bow Energy was Arrow Energy, which had itself been taken over two years previously, in a deal worth $3.6 billion.
The acquirers in that case were PetroChina Co Ltd [HK:857] and Royal Dutch Shell Plc [LON:RDSA].
Royal Dutch Shell is a partner in Woodside Petroleum Ltd’s [ASX:WPL] Browse project. One can only imagine the amount of cash the oil and gas giant has thrown at projects over the past six years…and how little return it will now get on those investments.
The clues are in the financials
One final point on Royal Dutch Shell Plc. You don’t have to look too far to see how much the company has invested in big projects in recent years.
Even a novice financial analyst can eke out a few clues from the company’s financial statements.
From 2009 to 2012, the company’s charge for ‘depreciation and amortisation’ averaged around US$14.5 billion per year. But, from the 2013 financial year onwards, the charge has increased.
For the 2015 financial year, ‘D&O’ cranked up to US$26.7 billion. That’s not to be underestimated. Some folks claim that depreciation and amortisation aren’t real charges, as they aren’t current year cash expenses.
But they are relevant. They reflect the investment that the company has made in the business. If those charges increase, but the returns the company is making shrink, it tells you the company isn’t getting the best use out of the capital investment.
The latest news story from Woodside helps to confirm that.
Browse won’t be the last
‘Oil fell before U.S. government data forecast to show rising crude stockpiles kept supplies at the highest level in more than eight decades.
‘May futures dropped as much as 1.2 percent in New York. Inventories probably increased by 2.53 million barrels last week, according to a Bloomberg survey before an Energy Information Administration report Wednesday. This compares to industry data that showed an 8.8 million barrel gain.’
You’ve seen what a glut in natural gas has done to not only the price, but to investments in gas infrastructure projects.
And you’ve already witnessed some of what has happened in the oil market. But have we really seen the worst in the oil market?
In 2011, the market was worried about the glut in natural gas, so the price slumped. But it didn’t take long to recover, with prices holding reasonably steady for three year…before the slump began anew.
Now natural gas is trading around the price it last saw in the mid-to-late 1990s.
Could there possibly be any chance that the market has the same thing in store for crude oil?
The crude oil price has rebounded since the recent low. Maybe this will be the bottom. Maybe the market will rally from here. But for how long?
Check out the long term oil price chart:
Price action in two different markets rarely follows the exact same pattern. But there are often a lot of similarities.
In this case, who’s to say that the crude oil price won’t stage a recovery which could last several years?
It could happen. But that doesn’t guarantee a long term price recovery any more than the natural gas price recovery did in 2012.
The old saying is that a cure for high prices is high prices, and the cure for low prices is low prices.
That’s playing out right now in natural gas and oil. The high prices of the mid-2000s sucked in billions in investment…or, rather, over-investment.
Ultimately, the world economy couldn’t cope with the increased supply, and so prices fell. That fallout of low prices is now seeping through the markets.
Firms are scrapping or shelving big projects, and some are even going bust as they exhaust all their cash flow.
As always, we’re prepared to be proven wrong, but our bet is that Woodside’s decision with Browse won’t be the last major project that the big oil and gas players put on ice.
High yield oil
Double uh oh!
More from Bloomberg:
‘The fortunes of junk-bond traders have never been more closely linked to oil.
‘The high-yield bond market has been rallying since Feb. 11, the exact day that oil reached a bottom. Prices on the bonds of speculative-grade energy companies are always linked to oil, but in recent weeks, credits outside the industry have also been moving with the commodity.’
Right now, the junk bond market is the oil market, and vice versa.
Where one goes, the other follows. If it goes down, watch out for the fireworks…
This won’t help
According to the Financial Times:
‘Saudi Arabia is prepared to join an oil output freeze next month without Iran taking part, a senior Opec delegate said, making a deal among big producers more likely.
‘Some of the world’s largest oil nations will meet in Doha on April 17 to discuss restraining output. The move follows a provisional agreement reached in February by Saudi Arabia, Russia, Qatar and Venezuela to keep production at January levels.’
Good news for the oil price, right?
Maybe. But maybe not.
What is likely to happen if Saudi Arabia freezes production levels? Get ready for an increase in production levels from marginal producers, especially shale producers in the US.
Even a short term 10% oil price increase could be enough to turn a small shale oil producer from a loss maker into a profitable enterprise.
If that happens, the oil price war will begin all over again. The oil price will begin to fall, and Saudi Arabia will increase supply in order to maintain market share and push marginal US producers out of business.
It never ends.