As oil falls below $30 (U.S.) a barrel, this is what I am waiting for: Corporate raiders and hedge fund bosses taking over big oil companies and liquidating them at huge return to investors.
The idea that investors can make a fortune from oil now seems absurd. Most of the one-trick-pony oil companies, that is, the ones that just pump oil out of the ground, have lost about 40 per cent in the past year and as much as 70 per cent since mid-2014, when oil was trading above $110. The integrated oil companies like Exxon, BP and Shell have fared better because they are protected somewhat by their refining and retail operations. They are down in the low double-digit rates in the past year. But their turn to walk the plank could come soon as the oil glut continues.
The share-price slaughter isn't due to falling oil prices alone. The strong U.S. dollar is partly to blame. But the real reason is that costs in every category, from operating expenses to capital spending, remain way too high. Spending is coming down quickly, but not quickly enough.
Now suppose you are a corporate raider or a hedgie and you want to make a fast buck in oil. What would you do? That's easy. Buy an oil company that is still spending billions on oil and gas exploration and development, cut those expenses to zero and liquidate the proven reserves. In essence (though not in the legal sense), the oil company would operate as an income trust by paying a gorgeously plump dividend as it funnels almost all of its profits to shareholders.
The lack of capital spending, of course, would put the oil company into slow-motion suicide mode as its reserves are run down and not replaced, or only partly replaced through, say, the purchase of smaller oil companies. But corporate death might never be so profitable. If there is no capital spending, many oil companies could spew out fortunes for their owners even at today's oil prices.
The idea of oil companies opting to kill themselves softly and slowly is just starting to make the rounds. Last month, British economics writer Anatole Kaletsky raised the idea in a Project Syndicate column. He noted that the self-liquidation route was exactly the one used by the tobacco companies, to the great benefit of shareholders. So why not oil companies?
The self-liquidation option becomes all the more compelling as it becomes apparent that oil prices could stay low for a long time as supply continues to outstrip demand and oil powerhouse Iran gets ready to make a splash in the export market. Even if they were to rise, the price would have to reach $60 a barrel – double the current level – and stay there or higher for many new oil projects, including the oil sands and deep offshore wells, to make economic sense.
The other reason self-liquidation is compelling is that Western oil companies simply cannot compete with state-controlled oil giants in the Middle East, such as Saudi Aramco and National Iranian Oil. The cost of producing a barrel of oil in the desert, thanks to relatively bargain pumping costs, cheap labour and prolific wells, is as low as a few bucks a barrel. The Western biggies simply can't compete with them, so why bother?
Capital spending among the Western oil companies is plummeting in response to the price collapse, but it's still pretty high because the oilman's mindset, in place for more than a century, hasn't changed: Replace what you pump and stay in business over the long term, replace more than you pump and earn a premium rating from investors.
Energy consultancy Wood Mackenzie this week reported that about $380-billion of oil and gas projects have been cancelled since 2014. Had they gone forward, their output would have thrown 2.9-million barrels a day of production onto the market. But the 75 top oil companies are still spending close to $500-billion a year on exploration and development, according to various estimates, perhaps in the belief that demand and prices are about to come roaring back, thrusting oil back up to $100.
High capital spending is a dangerous game as production proves remarkably resilient to price drops, the Chinese economy loses momentum and OPEC sheds its traditional role as price fixer. For the first time since OPEC was formed in 1960, the global oil market is truly competitive. All of this does not bode well for sustained high prices.
And we haven't even talked about climate change and the end of the oil era. Last month in Paris, 195 countries pledged to bring down their carbon emissions substantially for the sake of the planet. That means burning less oil and coal, if not now, soon.
At some point, oil investors will get the message that they don't have to suffer just because oil prices are low. When that happens, the oil industry will change like never before.
Eric Reguly