Skip to content

Crude oil slump: we’ve been here before

Version:1.0 StartHTML:0000000105 EndHTML:0000009905 StartFragment:0000003217 EndFragment:0000009869 About a month ago, the price of West Texas Intermediate crude oil broke below $30 a barrel (figures in U.S. currency), and stock markets tumbled.
Gordon Pape pic

Version:1.0 StartHTML:0000000105 EndHTML:0000009905 StartFragment:0000003217 EndFragment:0000009869

About a month ago, the price of West Texas Intermediate crude oil broke below $30 a barrel (figures in U.S. currency), and stock markets tumbled. It has since rallied from a low of $26 to recently above $36 per barrel. Some analysts had predicted that a retreat to the $20 level was a real possibility as none of the major producers had shown signs of reducing output. However, key Opec members have recently been in talks in an attempt to at least freeze production at current levels. So whither oil from here?

In response to the continuing rout, oil companies have again been slashing capital budgets and trimming jobs. BP announced recently it would cut its global workforce by 5%, or 4,000 positions, as part of a multi-billion dollar restructuring program. ConocoPhillips (NYSE: COP) recently reduced its 2016 capital expenditure budget again, to $6.4 billion, down from $10 billion in 2015. Similar announcements have been flowing from the energy sector for the past year.

We’ve been here before

It all sounds terribly grim, and the deep dive in the markets has left investors fearful of worse to come. Unfortunately, we’re not likely to see any immediate relief.  But as far as oil is concerned, don’t lose sight of the fact that we’ve been here before and managed to survive. In fact, according to the U.S. Energy Information Administration (EIA), the price of West Texas Intermediate (WTI) oil has fallen by at least 50% on five occasions since 1986. This is nothing new.

Back in 1997-99, the price of oil collapsed during the Asian financial crisis, dropping as low as $10 a barrel. Adjusting for inflation, that was the lowest price since at least the end of the Second World War. Interestingly, that was also during an El Niño period, which produced mild winters that cut demand just at a time when producers were pumping at the maximum.

Those were tough times for Canada in general and Alberta in particular. Just as we’re seeing now, there were mass layoffs and huge cuts in capital expenditures. About $2 billion was slashed from 1998 capex budgets compared with 1997 spending. Energy service companies saw their business drop by as much as 50%. Alberta’s housing market went into a deep slump, to the point where home abandonment due to high mortgage costs became a serious problem. And it wasn’t a short-term slump – the low prices continued from November 1997 to December 1998, a total of 391 days.

Global effects repeating

Many of the same global effects that we saw then are repeating today. Russia came under extreme financial pressure and was forced to devalue the ruble and suspend interest payments. The Venezuelan economy almost collapsed as oil revenue fell 37% between 1997 and 1998. Saudi Arabia experienced a drop of about 35% in revenue, resulting an increased deficit.

The crisis of the 1990s ended only when Saudi Arabia and some other producing nations decided that enough was enough and closed some of the spigots, reducing supply. The current crunch will almost certainly be resolved in a similar way, as recent talks are proving. The “x” factor is the timing.

So far, no one is showing any signs of blinking. But as the price of crude oil remains low, more companies are finding themselves in a financial bind. There’s a lot of dispute over what constitutes breakeven for production costs, but a paper published last year by the University of Calgary’s School of Public Policy cited reports from BMO Capital Markets and TD Securities that estimated the breakeven price of production for West Texas Intermediate light sweet crude from existing conventional facilities at between $16 and $51 a barrel. For mining (oil sands) projects, the cost range was put at between $34 and $54 per barrel.

Sector shakeout

Clearly, at current price levels many companies are facing operating losses. How long this can go on is anyone’s guess. AlixPartners, a consulting company, estimates that North American producers are losing about $2 billion per week at current prices. RBC Capital Markets says that since the oil price plunge started, more than 30 small companies, with collective debt exceeding $13 billion, have filed for bankruptcy.

Once the oil price has bottomed out, it may still take years before we’re back to 2014 levels. After the energy depression of 1997-98, the price remained stuck in the $20 to $30 a barrel range for several years. It began to move sharply higher only in late 2004. At that point, with demand from China growing exponentially, it rocketed all the way to $147 before the financial crisis of 2008 sent it tumbling back down to around $40.

Action now

Obviously, there will be tremendous profit opportunities in the energy sector when the next up cycle begins. But as matters currently stand, there is no reason to believe we’re at that point yet, despite the recent various “talks” by Russia and the Gulf state oil producers. Since the price isn’t going to fall to zero, there’s less downside now than there was a year ago. But the risk for investors remains elevated, especially in the case of smaller producers. Bide your time for now.

Courtesy Fundata Canada Inc. © 2016.Gordon Pape is one of Canada’s best-known personal finance commentators and investment experts. He is the publisher of The Internet Wealth Builder andThe Income Investor newsletters, available through his BuildingWealth.ca website. This article is not intended as personalized advice.