Who’s Really Getting Crushed with Lower Oil?
Mitch on the Markets (Special Edition)
Crude oil’s continuing downward spiral has left many puzzled, some unemployed and others bankrupt. As the WTI (oil pricing benchmark) plunges to below $30 per barrel, concerns about the Energy sector intensify, especially as there appears to be no clear indication of a rebound in the near term. Fluctuating profit margins are par for the course for the sector. Still, cratering oil prices have cost the U.S. oil and gas sector 70,000 jobs (200,000 worldwide) and growing negative sentiment has been reflected in equities too – this sector within the S&P 500 lost over 25% last year.
Although Energy, as a whole, is experiencing tough times, there are some within the industry facing even harsher conditions. These are mainly the regional, independent oil producers in the U.S., who only two years ago were the darlings of investors in fast growing business.
The Shale Revolution Loses Steam
The oil price slide has deeply bruised regional oil producers such as those in Texas and North Dakota. Sharp reductions in their oil rig count underscores the pain: Bakken in North Dakota has seen its rig count drop to 44 from around 200 four years ago and Texas has cut its rig count to 294 from about 750 last year. This is in stark contrast to the regions’ immensely prosperous times when the shale oil revolution helped them outperform markets even during the Great Recession.
Micro-economies are bearing the brunt of the downturn – North Dakota once saw rapidly accelerating employment, owing largely to shale production, and was one of the highest employment generating regions in the nation. In fact, growing popularity of the region was evident in its housing rents that were said to rival big cities.
There were and are numerous small regional drillers and refineries pressed with hard times but, to give you an example, let's look at the Dakota Prairie Refining, LLC. Before the oil price collapse began, refineries would benefit by purchasing oil from shale producers and then pocket a profit by selling more expensive refined output, namely diesel. Envisioning a similar objective, Dakota Prairie Refining LLC invested in its plant in 2014 at a time when diesel was selling at $100 more than the drilled oil near Bakken oil field. Unfortunately, the refinery was hit by losses soon after it began operation in May 2015 amid sharply falling diesel prices. Currently, diesel is selling in the region at just $16 more a barrel than the oil produced – not enough to stay in business.
One big problem with smaller refineries like Dakota Prairie is that they lack the adequate capacity and infrastructure to sell output to other regions. With less scope for competing in larger markets, the regional small players are the most hard-hit with falling oil prices.
Bigger Players Down, but Not Out
On the other hand, large U.S. oil corporations, though faced with challenges, seem to be in better shape compared to their regional counterparts. One of the reasons is that many of them are integrated oil companies – earnings from downstream operations bolstered by lower crude oil costs have offset, to some extent, reduced earnings from upstream operations. Exxon Mobil, for example, reported a decline in upstream earnings of -84.3% but a gain of +34.2% from combined downstream and chemicals earnings (Q4 ‘15 vs. Q4 ’14). Also worth noting is that Exxon’s earnings are still in the positive territory.
Furthermore, larger corporations are adhering to cost disciplines amid plunging oil prices. Chesapeake Energy, for instance, has reduced capital expenses by -59% in Q3 2015 from a year ago. Such cost management tactics will likely help companies generate profits when oil prices start to rebound.
Even though companies, large and small, are suffering in varying degrees due to falling oil prices, the larger ones will likely be better positioned when prices take a more favorable turn. Integrated oil corporations could take advantage of lower prices now to stock their oil reserves at lower costs and sell products at a higher price once fuel prices start to improve.
Bottom Line for Investors
Although Energy companies’ prospects are still largely uncertain in the near-term, it’s difficult to overlook the possibility of big gains if oil bounces back. Big U.S. corporations in the Energy space may be experiencing declines in earnings at present, but they are likely going to be some of the biggest gainers when oil rebounds. The opportunistic investor would see it this way: the current bearish sentiment regarding Energy equities could just as quickly turn into bargain buying opportunities.
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