'Abandon all hope, ye who enter here', is the famous line from Dante's Divine Comedy, but perhaps it should apply equally to prospective investors in the oil market, which was hit again overnight by falling oil prices.
According to CNBC, West Texas Intermediate (WTI) oil contracts for delivery in February slumped 6.7% to US$26.55 per barrel, while Brent Crude oil futures fell 91 cents to US$27.87 per barrel, a 3% dip. The last time we saw prices this low was in early 2003, although prices stayed under US$40/barrel for most of the 1980s and 1990s.
At today's prices of under US$30/barrel, many Australian producers like Santos Ltd (ASX: STO), Woodside Petroleum Limited (ASX: WPL), and Origin Energy Ltd (ASX: ORG) are getting uncomfortably close to their cost of production.
The major producers are rather cagey about providing information on their all-in costs of production (including corporate overheads) however, which can make it difficult for the average investor to determine how much profit they're making at a given time. Due to the nature of contracts and the timing of shipments, it also takes some time for price falls to work their way through to the bottom line.
With Woodside, Santos, and Origin shares down 25%, 62%, and 63% respectively for the year, investors are looking for bargains in the sector. However, with the full impact of falling prices yet to be felt on profits and dividends, and without an ability to predict the bottom of the market, buyers must be prepared to wear continuous volatility.
Over the next three to five years or so, the outlook for oil and gas appears to be substantially more positive, not least because company cuts to capital expenditure will now result in less production in the future.
However, the challenge will be for debt-laden or unprofitable companies to survive that long – any rebound in prices will be caused by a reduction in supply (e.g. through bankruptcies) or a drastic increase in demand, which is unlikely to materialise.
Buyers will be well served by taking a longer-term view, and focussing on companies with more stable balance sheets like Woodside Petroleum, rather than the heavily indebted Santos or Origin.
