Whatever happened to 'peak oil'? In last year's review of the FTSE 350 oil and gas sector, we ventured that crude oil pricing had become less predictable "not because we are running out of resources but because we are producing far more of the stuff than previously anticipated". That seems like an understatement, with hindsight.
The continued expansion of the US shale oil industry and falling demand from mature markets have combined to create a global surplus amounting to 1.8m barrels a day. In order to preserve market share, and presumably to force lower-margin US shale producers out the market, Opec (or more accurately, Saudi Arabia) has chosen not to reduce production quotas.
At the time of writing Brent crude was down 59 per cent on its end-June rate and by the time you read this, who knows? After all, Goldman Sachs has just halved its forecast for the benchmark's first-quarter average to $42 a barrel. We have yet to discover a floor price, although we're fast approaching a level that would render 1.5m barrels of daily output uneconomical, according to recent research from consultant Wood Mackenzie.
The slump is already having the desired effect - at least from a Saudi perspective. The number of rigs in use in the US fell every week during December and, midway through this month, hit their fastest rate of decline since February 1991, according to data from oilfield services group Baker Hughes. However, any slowdown in the rate of production growth in the US probably won't become fully apparent until the third quarter. Nevertheless, the negative outlook on prices has convinced already cost-conscious FTSE 350 drillers to shelve big-ticket capital projects. Most notable was Royal Dutch Shell's (RDSB) decision to scrap the multi-billion-dollar Al Karaana petrochemical development in Qatar.
Even with the second-half deterioration Brent crude averaged $97 a barrel through 2014, so the effect of lower prices won't be immediately apparent in the FTSE 350 constituents' full-year figures. But earnings could be impacted by a flurry of fair value writedowns. Premier Oil (PMO) already plans to take a $300m impairment charge against its assets, in addition to cutting jobs and investment to reduce costs.
Meanwhile, BP (BP.) has shed hundreds of jobs linked to its North Sea operations as it seeks to further rationalise costs. With a general election looming, BP's decision has prompted an urgent ministerial review into the state of the North Sea oil and gas industry. It seems inconceivable that the government will back away from instituting a less onerous tax regime for the industry, but don't underestimate the Treasury's capacity to underwhelm. BP is still moving ahead with its Clair Ridge and Schiehallion projects. Inactivity on the part of Chancellor George Osborne could, however, prompt North Sea operators to decommission some ageing, marginal offshore fields.
If the price falls weren't bad enough, BP is also struggling with a number of unfavourable court rulings linked to 2010's Gulf of Mexico spill. And the group's activities in Russia are again proving a source of anxiety. The crisis in Ukraine, and the subsequent imposition of sanctions against Russia, present real problems for the group given its near-20 per cent stake in state-controlled energy giant Rosneft.
| Company name | Share price (p) | Market value (£m) | PE ratio | Dividend yield (%) | 1-year performance (%) | Last IC view: |
| Afren | 21 | 233 | 0.7 | nil | -87.1 | Hold, 97p, 1 Sept 2014 |
| BG Group | 886 | 30,245 | 11.4 | 2.0 | -34.0 | Hold, 186p, 20 Aug 2014 |
| Nostrum Oil & Gas | 505 | 950 | NA | nil | -31.9 | na |
| Ophir Energy | 130 | 744 | 18.0 | nil | -56.7 | Buy, 206p, 14 Aug 2014 |
| Premier Oil | 149 | 762 | 5.3 | 3.4 | -47.2 | Hold, 340p, 21 Aug 2014 |
| Soco International | 260 | 861 | 18.0 | nil | -33.7 | Buy, 431p, 29 Aug 2014 |
| Tullow Oil | 385 | 3,501 | NA | 3.1 | -56.8 | Hold, 764p, 30 July 2014 |
| BG Group | 886 | 30,245 | 11.4 | 2.0 | -34.0 | Hold, 886p, 29 Dec 2014 |
| BP | 426 | 77,680 | 13.6 | 5.6 | -13.3 | Sell, 405p, 10 Dec 2014 |
| Royal Dutch Shell B | 2,227 | 138,704 | 13.9 | 5.1 | -2.05 | Buy, 2,302p, 3 Nov 2014 |
Favourites
We still favour Shell from an income perspective, despite the risk that a prolonged fall in oil prices could sap cash flow - making it harder to cover dividend payouts. The cancellation of the Al Karaana investment points to a renewed focus on capital discipline, though. Shell's dividend yield now stands at a tempting 5.2 per cent and it should be remembered that the group hasn't cut its payout in nearly 70 years - a distinction it would be keen to preserve.
Outsiders
We exited our long-running buy call on Afren (AFR) in March 2014 - just as well we did. By then, Afren's share price was 279 per cent up on our initial advice, but the group's market value subsequently collapsed due to a boardroom scandal and the oil price falls. There was further trouble at the outset of this year when the group revealed that it had substantially overstated its oil reserves at licences in the Kurdistan region of Iraq. A recent bid approach from Seplat Petroleum Development Co (SEPL) has helped support the shares, but caution remains wise.
