Oil has had a staggering slump – but we haven’t seen capitulation yet

Oil companies face a huge challenge – prices are collapsing, but they can't stop pumping. The slide won't stop until the bankruptcies begin, says John Stepek.


The oil sector is putting a brave face on it

China's been taking up a lot of time this week, but today I want to look at something arguably even more important the price of oil.

Oil has dived. It's back where it was in 2009.

That's left the oil giants sporting some pretty impressive yields.

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Is it time to buy? Or are we looking at an epochal shift?

The future is smart car shaped

Put simply, as far-fetched as it might seem, I think (and hope) that we're heading for a future where the majority of cars are self-driving electric ones. Most of us won't even bother owning a car. We'll just pay a monthly subscription to summon one on our smart devices as and when we need it.

I realise that some people love their cars, and that's fair enough but I'd happily swap mine for a reliable on-demand taxi service. No messing about with finding parking. No dealing with rip-off repairs. No hunk of metal rapidly depreciating in front of your house. I reckon a lot of other people would find that attractive too.

Clearly, that all represents a big shift in the way the world works. But the ingredients are coming together.

You've got autonomous vehicles already driving around the roads of various US states. You've got functional even sexy' electric cars in the form of Tesla. You've got ever-improving solar costs, offering the tantalising prospect of cheap energy to charge your batteries.

And you have data-hungry network beasts like Google and Facebook and Apple who would love to have complete knowledge of where you are at every given moment in time, so they can sell stuff to you more effectively.

That sounds a little sinister (because it is a little sinister), but it certainly represents an incentive for these companies to keep developing in this direction.

If you're having difficulty swallowing this, just think of the car as the next frontier of smart' devices. Apple and Google want us on their network of phones. Next they'll want us on their network of cars.

It'll take a while to get there. Batteries need to get better. The price of solar power needs to come down even further. And the social and legal barriers to automated cars are massive how easily can automated cars co-exist on the road with unpredictable human drivers? How does that process evolve?

However, the roadmap is there. It might seem like science fiction, but it makes sense for the industry to move in this direction. And in the longer run, that'll likely mean the demise of the petrol engine.

Oil companies are heading for a heap of trouble

oil price

As of right now it means, frankly, not a lot. Instead, the oil price is plummeting for the following reasons.

Firstly, everyone is pumping away like there's no tomorrow. That's because they all need the cash. Saudi Arabia needs the money. Iran wants the money. US shale producers need the money.

That's the fundamental flaw with the cartel' model. You can only switch off the taps if you have some other income source to live off. Same goes if you've borrowed a load of money you need to make those payments, and for that the cash needs to be coming in the door.

So there's plenty of supply out there and that looks set to continue until someone goes bust and simply can't keep producing.

The second problem is demand. The fear is that the global economy is in big trouble, mainly because of China's slowdown. Falling demand plus rising supply makes for lower prices.

So can this carry on, or is this a buying opportunity?

It's tricky. I thought oil might have bottomed out when it hit just above these levels earlier this year, then rebounded. Clearly I was wrong. And clearly oil prices could fall further. $40 a barrel is only cheap relative to the last decade or so. Oil has been a lot lower for a lot longer in the past.

At the same time, these companies do need oil prices to be higher than they once were, in order to survive. According to Bloomberg, profit margins for the MSCI World Energy Sector Index companies are at their lowest since at least 1995 which is as far as the data goes back.

In other words, the pressure is seriously on. And it's only a matter of time before the weakest companies have to break.

Again, as Bloomberg notes, "the number of oil and gas company bonds with yields of 10% or more, a sign of distress, tripled in the past year". There are nearly 170 companies in this category across North America, Europe and Asia. "The ratio of net debt to earnings is the highest in two decades. If oil stays at about $40 a barrel, the shakeout could be profound."

When I look at something like Royal Dutch Shell, which has managed to sustain its dividend through thick and thin for 70 years, and now yields more than 7%, I have to say I'm tempted.

At the same time, this doesn't yet feel like capitulation'. I suspect that will only come when the bankruptcies start to come through. And that'll be the point at which people start questioning the ability of the really big names to survive. People won't be looking for the bottom anymore they'll be declaring the end of the world.

So it's very much on my radar. But for the moment, I'd rather bide my time and see if we get this profound' shakeout.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.