March 01, 2015

Black Gold, Texas Tea… without oil, the industrialization of the world would have not happened at the pace that it did. But rapid growth in the demand for oil comes hand in hand with volatility. So when the classic boom to bust happens with oil, what happens to the global economy, bankruptcies, and equity markets?

Historic Oil Spikes and Past Global Recessions

For the last 40 years, oil has been a volatile commodity that has had many peaks and troughs. In this article, we will look at the fallout. Does the drop lead to an increase in bankruptcies? Recessions? What is the impact on oil- and gasrelated stocks?

Before we can start that analysis, we must look at historic boom and bust cycles:

  • The oil embargos of 1973 and 1979 caused significant increases in the price of oil and, in turn, global recessions. The price of oil was affected for over 10 years. Both embargos threw the U.S. into recession. In 1985, the price of oil dropped rapidly as the Organization of the Petroleum Exporting Countries (“OPEC”) found itself in an oversupplied position.

  • During the ensuing 10 years (with the exception of a quick boom and bust in 1990 due to the Iraqi invasion of Kuwait) the price of oil, though volatile, traded in a tight band of $25 to $40 per barrel in 2014 (as adjusted for inflation using the Consumer Price Index).

  • In 1997 and 2001, the collapse of the Asian financial markets and the terrorist attack on September 11, 2001 respectively, caused declines in the price of oil as the markets reacted.

  • Then, the price of oil had a rapid increase as markets in India and China grew, the U.S. entered the Iraqi war, OPEC began a series of production cuts to keep oil prices high, and strikes began in Venezuela.

  • However, in the fall of 2008, with the collapse of the financial markets, the price of oil plummeted.

  • With the recovery of the price of oil came technological advances, such as horizontal drilling and hydraulic fracturing, which enabled oil and gas to be produced in vast quantities.

“The next round of high prices is likely to start later this year, as crude rebounds to the $80s and $90s, perhaps pushing to the $100 level by late in the year or early next.”

— John Hofmeister, Former president of Shell Oil USA

Over the last 40 years, the oil and gas industry has become much more sophisticated in how it handles downturns. We now have an active financial market that allows commodity risk to be mitigated. In addition, the exploration and production companies have experience with downsizing and can quickly reduce capital spending and headcount. New technologies continue to improve the ability to find and efficiently produce oil and gas, thus reducing risk and improving returns.

In addition to these changes, capital has been on the sidelines waiting to enter the energy space. Therefore, many private equity firms and hedge funds are poised to take advantage of the boom to bust cycles for which oil is known.

The Price of Oil and the Equity Markets

Traditionally, stock prices for oil and gas exploration and production companies have been virtually in step with the price of oil. The following chart shows how close the correlation is between changes in the price of oil and changes in the stock price. However, during 2013, the exploration companies’ stock prices remained high as the price of oil dropped. By the end of the year, the market was adjusting and stock prices were collapsing at a higher pace than oil to correct this anomaly. Here you see the Alerian MLP Infrastructure Index (a composite of companies involved in the transportation, storage, and processing of energy commodities) in comparison to the spot price of oil. It shows that midstream stocks do not react to the booms and busts, but have pretty steadily grown over the last eight years, with the exception of 2008 and 2009. The climb that you see starting in 2009 is based on the increased volume of oil, rather than the price.

“The price drop has been too fast and too far for the fundamentals… The market is only focusing on the negative. It’s very hard to see a trigger which could turn the sentiment.”

— Hans van Cleef, Senior Sector Economists, ABN ARMO

The Price of Oil and the Equity Markets

Traditionally, stock prices for oil and gas exploration and production companies have been virtually in step with the price of oil. The following chart shows how close the correlation is between changes in the price of oil and changes in the stock price.

However, during 2013, the exploration companies’ stock prices remained high as the price of oil dropped. By the end of the year, the market was adjusting and stock prices were collapsing at a higher pace than oil to correct this anomaly.

 

Here you see the Alerian MLP Infrastructure Index (a composite of companies involved in the transportation, storage, and processing of energy commodities) in comparison to the spot price of oil. It shows that midstream stocks do not react to the booms and busts, but have pretty steadily grown over the last eight years, with the exception of 2008 and 2009. The climb that you see starting in 2009 is based on the increased volume of oil, rather than the price.

Downstream companies, such as refineries and retailers, often show reduced value when the price of oil is rising and increased profits when the price is dropping. Therefore, refiners will do well in a time period where prices are dropping, but that will even out as the price bottoms out and a recovery in the spot price begins its climb back up.

Do Bankruptcy Filings of E&P Companies Follow a Drop?

Chart 5 shows the boom and bust cycles since 1980 and the number of energy-related bankruptcies filed using the UCLALoPucki Bankruptcy Research Database (“BRD”). The BRD is a dataset consisting of approximately 200 fields of data on each of the approximately 1,000 large, public company bankruptcies filed in the United States Bankruptcy Courts since October 1, 1979. We have included companies who have SIC codes for Crude Petroleum and Natural Gas, Natural Gas Liquids, Oil and Gas Field Services, Petroleum Refining, Gas Production and Distribution, Petroleum and Petroleum Products, Bituminous Coal and Lignite Mining, and related Specialty Chemicals. It should be noted that this database does not include small companies or privately held concerns, which may be more highly impacted by the swings in prices. However, it shows that within a few years after the drops in prices in 1985, 1991, 1997, 2001, and 2008, there are more bankruptcies than the historical average.

Do Transactions Accelerate or Decline After a Drop?

Chart 6 shows the number of oil and gas merger and acquisition transactions by year against the spot price of crude oil. It is hard to see a direct correlation. That being said, recently this sector has seen increased investments by private equity firms and hedge funds. Although historically there is not a correlation, we can expect increased activity based on the amount of money focused on the sector.

Drops in the Price of Oil and Recessions

In Chart 7, you can see that most of the booms have led up to recessions while the bust happens right at the beginning of the global recession. I will leave the classic question of “Which comes first, the chicken or the egg?” to the economists. However, there are a few things that happen in a recession that are worth mentioning. For example, increases in the price of oil can lead to increased development of oil and gas reserves, creating a supply and demand imbalance. Such an imbalance tends to be exacerbated by a slowdown in industrial use of oil products, thus causing a quick drop in oil prices. This drop in oil prices then helps to fuel the recovery. Since 1997, oil has rebounded to previous prices within a few years. It should also be noted that with the advent of global recessions, the dollar typically becomes stronger, which also causes oil prices to decline. In most global recessions, investors are looking for a safe haven for their investments. As such, the U. S. dollar becomes stronger against other currencies. Since oil is traded in dollars, the impact on the cost of a barrel of oil is very dramatic. Chart 8 shows the correlation.

What Can We Expect?

We can expect the unexpected. In 2008, we could not see the success that our new technologies could bring. Innovation will continue to drive changes in supply and demand, volatility will continue to impact decisions that are being made in the oil industry, and in the future, as in the past, global politics will still cause oil prices to change.

“A lot of our projects are long term to have production in five or six years. And that is a problem. If you are cutting capex drastically now - we can have a lack of production in four or five years creating a new increased oil price at $200 maybe.”

— Claudio Descalzi, CEO of EniIran’s Oil Minister