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The trouble with price wars is that they almost never turn out the way the participants hope they are going to.
It is too late for OPEC to stop the shale revolution. The cartel faces the prospect of surging U.S. output whenever oil prices rise, says Ambrose Evans Pritchard
For example, when Rupert Murdoch slashed the price of The Times of London newspaper in 1993, it sparked a price war with the Daily Telegraph that lasted a decade and roped in other “quality” papers in the U.K.
In the end, nobody really won, and perhaps least of all the Times. Its circulation increased over the decade, but it spent gobs to acquire those readers while other factors were overtaking the newspaper industry – such as declining advertising revenue – which eventually helped make low, low prices unsustainable.
The Times-Telegraph game of chicken is now ancient history, but investors might be seeing a similar dynamic playing out in what is today’s most relevant price war: oil.
As the oil price war continues, instability and unpredictability are likely to remain the rule in global markets. For investors looking around the corner, the question becomes who will survive and who will thrive when prices rebound?
Saudi Arabia has shown no signs of wavering in its policy of maintaining production. The party line from the Organization of the Petroleum Exporting Countries, led by the Saudis, is that it is keeping production at around 10 million barrels per day in expectation of increasing demand (which lower prices should stimulate) and dwindling supply (thanks to weaker players exiting the market).
Yet it’s now accepted wisdom that the Saudis’ play is designed to take higher-cost (non-OPEC) producers out of the game – a classic price-war strategy, and maybe not a bad one when you’re among the biggest, lowest-cost producers on the planet.
But if that’s so, it’s not exactly working out as planned, at least not yet.
On the demand side, the rosier picture that would support higher prices has yet to develop. Global economic growth has slowed, and the International Energy Agency expects oil demand to decline through 2015 and into 2016.
On the supply side, if OPEC’s goal is to put the U.S. shale oil industry or Canada’s oil sands out of production, it’s not happening.
The Saudi Central Bank admitted as much in a report last week, saying that the main impact of lower prices on non-OPEC producers “has been to cut back on developmental drilling of new oil wells, rather than slowing the flow of oil from existing wells.”
Although overall rig counts in the U.S. are down on the year, they’ve been rising for five of the past six weeks, according to statistics from driller Baker Hughes Inc., which is one of the factors that sent oil prices on their slide last month.
Some analysts believe the driving factor in growing rig counts is that the majors, such as Exxon Mobil Corp., Chevron Corp. and BP PLC, are aggregating exposures to U.S. production.
Observers have long expected low oil prices to create a wave of consolidation in the oil industry, particularly in the shale business, where there are a host of smaller players that seem ripe for the taking by Big Oil. (According to Goldman Sachs, the majors own only about five per cent of U.S. shale oil production.)
In large part because of those M&A expectations, producers’ valuations have stayed high. But at some point, if prices remain low, that won’t be case, and smaller players may be forced to shutter or sell.
By contrast, large non-OPEC producers have assiduously cut costs and cancelled capital expenditures, but they’ve been able to largely maintain or even grow current production.
Exxon’s second-quarter profit fell by more than 50 per cent year over year, and earnings in its upstream (exploration and production) business dropped by 75 per cent. It cut drilling expenditures, meanwhile, by 12.5 per cent.
But here’s the rub: production actually increased by 3.6 per cent. And it’s not like Exxon lost money. Even at these low, low prices, it still earned US$4.2 billion in the quarter.
Closer to home, you can look at Suncor Energy Inc., which has pared costs and capex, but recorded a very healthy profit last quarter despite the oil price haircut.
Other large energy companies with existing, long-term production should be similarly positioned, with lower future revenue expectations, but still-steady revenues and profit. They also have plenty of cash to survive and acquire, if the price is right.
Put all these factors together and it’s hard to see a situation where oil prices don’t stay low for a good long while.
But it’s never too early to handicap who will be left standing when the war is over.
On the geopolitical front, OPEC and the Saudis are paying a high price for their strategy; already, weakened economies in some OPEC member countries (Venezuela, Ecuador, Libya, etc.) are aggravating political instability, and Saudi Arabia is tapping into its (admittedly vast) cash reserves.
Big Oil, on the other hand, might be positioning itself to reap the benefits of devaluation across the industry.
One man’s price war is another man’s buying opportunity.