According to data published by the NASDAQ, Oil prices have dropped so low that a barrel of oil is currently retailing at about $36. In comparison, the price of a barrel of oil was more than $100 as recently as 2014. On the one hand, consumers and some manufacturers have benefited greatly from low oil prices because they translate to lower vehicle and machinery fueling costs. On the other hand, manufacturers of oilfield products are facing declining revenues because their main client base (oil industry players) is dwindling by the day.
The Impact of Low Crude Oil Price on the Producers of Oilfield Products
According to data published by the Federal Reserve, manufacturers of energy industry products started to slide into the red during the first quarter of 2015 when drilling budgets across the energy sector, especially in the US, began shrinking. At the same time, operators of drilling businesses stopped hiring and some even began laying off workers. The few, lucky companies that could afford to continue operating instituted cost cutting measures including imploring manufacturers of oilfield products to lower their prices. In fact, the owner of Houston-based oilfield equipment manufacturing company Ocean Fab, Greg Bright told a Houston Chronicle reporter that he had started receiving letters from clients requesting lower prices in light of falling oil prices. Moody’s Investors Service report published during the same period had anticipated this outcome bluntly stating, “Oil and gas exploration and production companies, and the companies that supply them, will be hurt by lower crude prices.”
Why Low Oil Prices Affect Drilling Activity
Drilling for oil and gas ramped in the US over the last five years largely due to high oil prices. These enabled drilling rig operators to break even, and cover operating costs easily. However, drilling costs vary depending on location, drilling technology deployed, and the scale of drilling operations. Research done by Tortoise Capital Advisors in 2014 found that breakeven prices for drilling companies operating in the Eagle Ford shale basin ranged from $49 to $102. This means that the companies operating in this location cannot remain profitable when energy prices fall below this breakeven price range. As such, oil/gas drilling firms that halt operations simply stop purchasing the equipment they use to erect and operate oilfield infrastructure. In turn, suppliers and manufacturers of oilfield equipment face the risk of order deferrals or in worst-case scenarios outright cancellations. In addition, low oil prices scare investors due to inelastic and inadequate demand, high operational expenses that consume a large percentage of recurring revenues, long exploration cycles, as well as the capital-intensive nature of oil/gas drilling. When combined, these factors constitute high barriers to entry and risks that very few investors would dare add to their portfolios.
Effect of Low Oil Prices on Oilfield Products in the US
A survey done by McKinsey Energy Insights found that operating margins in the US energy sector experienced the worst deterioration compared to other countries worldwide. As a result, companies involved in the oilfield services industry will face significant headwinds if prices remain below the $60 to 70 per barrel level over the next few years, according to an article published by Forbes magazine. Nevertheless, it is worth noting large and financially strong oilfield products manufacturers will survive this downturn and probably emerge bigger thanks to mergers and acquisitions involving weaker competitors. In this case, the roughly 20,000 small and mid-size businesses including producers of oilfield products that support the US oil and gas industry are the most vulnerable, according to a report from the Manhattan Institute for Policy Research.
A troubling research study carried out by Rystad Energy found that up to 70% of staggering oilfield product purchases were related to offshore drilling rigs; and include subsea drilling equipment expenses, well maintenance and operating costs, as well as hiring drilling contractors. This amount is significant because it translates to about 5% of the $8 trillion spent when oil prices are at or above $80 per barrel. Rystad Energy expects businesses that manufacture or supply products related to subsea drilling to be hit the hardest by the current low energy prices. Fortunately, oilfield product companies involved in the maintenance and operations side have a limited downside since oil and gas extraction companies are likely to keep existing wells operational or in viable condition instead of shutting them down all together.
Overall, 18% of the energy extraction projects that will sustain a significant hit, in terms of oilfield product purchases, are in South America. Other regions that will experience similar losses include North America, Asia, and Africa. Energy extraction projects in Europe, the Middle East, Russia, and Australia will not be hit as hard by the drop in oilfield product purchases forecast by Rystad Energy.
Oil Glut Timeline
Given the scenario discussed above, producers of oilfield products will only breathe easier when energy prices rise above $80 per barrel. Investing in new wells when oil prices are at or above this price target makes financial sense, according to an investment outlook paper published by Fred Alger Management, Inc., an investment advisory services company. Unfortunately, energy industry analysts do not expect oil prices to hit the $80 mark in the near future. For instance, data from the US Energy Information Administration shows that global oil inventories will grow by one million barrels per day throughout 2016. In 2017, this figure will increase by an additional 300,000 barrels per day to push oil inventory growth to 1.3 million b/d, which the EIA says is substantially higher than previous forecasts meaning the current oil glut is unlikely to end in the next year or two. There is, however, the enduring hope that prices will increase before the year 2020. At this time, all we can do is continue to hang on and ride the waves until the glut returns to a manageable price rate for both consumers and producers.
At Essentra Pipe Protection Technologies, we are adaptive to the ups and downs of changing oil prices, and we will continue to serve and meet the needs of our customers from all corners of the globe.