The rapid decline of oil prices have dominated the financial news the second half of 2015. Each time you turn on CNBC chances are a Wall Street analyst is discussing the latest movement in oil prices. Just the other day one proclaimed "I believe we hit the bottom!".

The price of oil has fallen from $110 per barrel in 2014 to $35 at the end of 2015. The reason for this massive drop boils down to the economics of supply and demand. On the supply side, the world produces more and more oil. The United States and Canada keep raising production year after year. The Organization of the Petroleum Exporting Countries (OPEC), a cartel of oil producers including Saudi Arabia, Iraq, the United Arab Emirates and other gulf allies, recently agreed to increase the production of oil because they don't want to lose marketshare and because they know it drives the U.S. shale oil producers out of the market. Last, but not least, Iran is about to re-enter the world of oil markets in 2016 after years of sanctions and isolation. On the demand side, we see that demand for fuel is lagging a bit, resulting in an overproduction of oil.

When there is more supply than demand and no one is cutting production, the price of oil will keep dropping, and eventually the world might run out of places to store all the excess oil. Many oil producer are struggling to maintain their profitability and incurring losses.

I'm not an expert on the oil industry, and I certainly understand that it is impossible to predict the future, but to me it seems the worst is yet to come. As I see it, there are four scenarios that could play out: (1) oil producers agree to balance supply and demand by cutting production, (2) the demand for oil picks up as the world's economies strengthen, (3) the supply of oil starts to slow down as oil producers can't afford the investments to sustain production, or (4) enough oil producers go out business and supply and demand is rebalanced that way.

I don't have a crystal ball, but I consider a combination of (3) and (4) to be the most likely outcome. Oil production companies have been slashing their capital budgets throughout 2015 to stay in business. Multibillion-dollar explorations and production projects have been delayed or cancelled. This should cause oil production to drop naturally in the future. To weather the storm, cutting capital budgets might not be enough; oil companies might have to increase their debt levels, and those that can't raise more debt might have to dig deeper and cut their dividend. I wouldn't be surprised if we saw various oil producers cut their dividends in the second half of 2016, and witnessed a series of bankruptcies or acquisitions in 2017.

Because of the drop in oil price, many of the oil companies have become unusually cheap, often trading at 10 year lows. For people with a 5-10 year time horizon, it is probably a great time to buy stock in one or more integrated oil and gas super majors, especially if you stick with the few that are still able to support their dividend. At the same time, I believe the worst is yet to come. As someone investing part of his paycheck for retirement, I'll sit on the sideline a bit longer until the above scenario starts to play out. In the mean time, I'll keep wondering and learning why Wall Street analysts keep calling the oil bottom ...

Disclaimer: I'm long XOM with a cost basis of $68 per share, and would probably add to my position if XOM hits $70 per share again. Before making an investments, you should do your own proper due diligence. Any material in this article should be considered general information, and not a formal investment recommendation.

Comments

Paulius Pazdrazdys (not verified):

Interesting article. I think that oil price drop is impacted by electric cars emerging to main market. And of course related fact - global warming iniatiatives are also pushing to use more green energy which lowers demand. Solar energy expansion and electric cars with Tesla Model 3 coming up (gigafactory will be opened also) oil prices will only suffer more.

I admire what Elon musk is doing in renewable solar energy and electric cars industry. His quote about how solar could be used to power entire US: "You could take a corner of Utah and Nevada and power the entire United States with solar power." #AGU15. Article about that: http://www.techinsider.io/elon-musk-solar-panels-to-power-the-earth-201…. Elon is one big problem for these oil magnates, who are stuggling to make their profits. Interesting time to live in.

Dries:

First, I'd love to see sustainable energy win and fossil fuel die. Unfortunately, most of the world has just begun to consume oil ...

Oil provides the raw material to make a wide range of products. In fact, it is nearly impossible to get through a day without using multiple products that contain oil; shampoo, toothpaste, shaving foam, lipstick, plastics, contact lenses, soaps, detergents, washing powder, paints and clothing all contain petroleum products.

Talking about cars specifically, in the United States there are 82 cars for every 100 people, China has just 7 per 100 people, and India has just 4 cars per 100 people. The world's vehicle sales will continue to increase, and today the vast majority of new cars sold is still using gasoline/diesel. I could be wrong but I don't think electric cars have a meaningful impact on oil consumption yet.

Longer term, there is no doubt that the oil industry will face headwind from electric cars. Transportation (cars, planes, boats) is responsible for 70% of the world's oil consumption. Depending on how fast electric cars/planes/boats are adopted, oil could peak within the next 10 years. It's very difficult to forecast the rise of emerging technology; a lot will depend on the rate of innovation, government policies, etc.

But even after "peak oil", integrated oil and gas majors could make for good investments because oil and gas could become increasingly scarce, they could get into sustainable energy, etc. Time will tell!

Thanks for your comment, Paulius. It actually makes me think that "peak oil" is a much more interesting topic than "bottom oil". I might start thinking and researching "peak oil" instead ... :-)

Patrick (not verified):

If you are true to your first sentence above ("I'd love to see sustainable energy win and fossil fuel die."), then you must divest from fossil fuels. It's one lever we, ordinary people, have to influence where our future heads and help it go towards a liveable one.

While I searched for a definition of fossil fuels divestments (http://gofossilfree.org/what-is-fossil-fuel-divestment/), I found the following article from a couple of weeks ago that explains that the low price of oil is good for the environment: http://www.theguardian.com/commentisfree/2015/dec/11/cheap-oil-climate-….

I'll be happy to discuss this further, even in a BoF ;-), but now need some sleep (I therefore hope the above is intelligible). Cheers.

George DeMet (not verified):

It may not look like it right now, but the oil industry has put themselves on the path to irrelevance by continuing to waste vast sums of money pursuing ever more challenging and expensive methods of extracting oil from under the ocean, while other more innovative companies are throwing their R&D dollars into more profitable alternative energy sources. It is true that the world will continue to use oil for many decades to come, but its days as the world's primary energy source are numbered.

As Anatole Kaletsky argues, Big Oil companies (and their shareholders) would be better off abandoning their scarcity mindsets, selling off their reserves while they can, and spending the money they currently spend on oil exploration on transforming themselves into centers of innovation for alternative energy.

Dries:

I'd love to see the oil companies invest in alternative energy sources. They could make a meaningful impact on the world. In fact, I have always assumed that they will; they'll likely be forced to to stay in business in the long run, but it is probably too early still.

ExxonMobil has been in business for 125+ years. In 2014, ExxonMobil had a net income of $32 billion on $394 billion of revenue. SolarCity, as an example, operated at a $56 million _loss_ on $255 million in revenue that same year. SolarCity's market cap is $5 billion so ExxonMobil could buy SolarCity with roughly two month's profits. But as you can see from the numbers, it might be too early as buying a company like SolarCity doesn't impact their top/bottom line yet.

George DeMet (not verified):

While I appreciate the work that startups like SolarCity have been doing to explore innovative consumer-based business models for alternative energy, I think the companies that investors should be looking at are established ones who have the proven capacity to deliver alternative energy platforms at scale, like GE, Mitsubishi, and Siemens.

On the automotive side, it's important to keep in mind that the best-selling electric car in the world is not made by Tesla, but by Nissan. Toyota is leading the way in fuel cell technology, with their first vehicles already on the road.

Again, I love the work that Elon Musk is doing to get people excited about alternative energy and electric vehicles, but from an investor's standpoint, I think it's important to look at the companies who know how to execute at the scale required to make alternative energy efficient and profitable.

Jeff Sutherland (not verified):

It is game over for the oil industry. The price of solar has improved over 5000 times against oil since the 1970's. I've dumped my oil burner for geothermal run by electricity produced by solar panels. I've dumped my obsolete gas guzzling cars for Tesla's.

Basically solar is on a Moore's law curve like computer chips and there is no end in sight. The Saudi's have already announced that the majority of their new energy production in coming years will be solar.

You can read all about this in "Clean Disruption" by Tony Seba.

This year there were days when the total energy production in Denmark was delivered by wind.

And if Moore's law ever runs out for solar there are even more innovative energy technologies in the pipeline.

The most interesting new commercial solar power plants have energy storage that allows them to run 24/7. There are a couple in Spain and one being built in the U.S.

Warren Buffett is investing in solar and shutting down 7 coal plants.

Right now the ocst of the paperwork in our obsolete municipalities is staring to be more than the solar panels.

Dries:

I didn't know the book Clean Disruption (Tony Seba), but I've added it to my wishlist. Thanks for the recommendation, Jeff!

Who do you think will be the ExxonMobil and Chevron of clean energy?

Lenz Grimmer (not verified):

I have my doubts that the traditional fossil fuel companies have any serious motivations to change their existing business models into becoming leaders in the fields of alternative energy. Like the car manufacturers have optimised their product lines on building cars with combustion engines, fossil fuel companies have made large investments in their existing and proven technologies and processes that they won't stop milking as long as they can, to make investors like yourself happy. As recent publications revealed, the fossil fuel companies knew about the ongoing climate change since the 70ies. Did it make them change anything?

BTW: while researching "peak oil", this article might be an insightful read as well: http://resourceinsights.blogspot.de/2015/03/lipstick-on-pig-america-as-…

ybabel (not verified):

It's called a "duopole of Stackelberg". Basically it's when the 1st producer and the 2nd producer are trapped in "I must produce more to keep my market share". It will end badly, either Shale oil or the Saoudis (or both) loose the arm-wrestling contest.

Oil need's HUGE (very huge) investments to keep producing it's "unconventional" fields, and, the world cannot afford any-more to pay for non cheap oil, as the lasts 3/4 year's have demonstrated.

There is one, and only one way out : innovation. But we cannot force innovation, and, like everything in economy it's subdued to the diminishing returns.

Dave (not verified):

One of the more interesting things to see play out is what happens to all the companies who took out hundreds of millions of dollars each in loans expecting oil to be $80+ barrel. I think you will soon see - and as of Mid February of 2016 are already seeing - many of the smaller oil players start to go bankrupt. For this reason I am heavily short the banks and companies that hold this debt: TCBI, BOKF, WDR and HYG to name a few.