A fortnight into 2016 and Goldman Sachs' September prediction of crude oil at $20 a barrel no longer seems quite so alarmist. FTSE 350 oil and gas producers are now faced with a deteriorating market environment in a year in which price hedges will start to evaporate and new production threatens to exacerbate swollen inventory levels.
Estimates vary, but the surplus in global crude markets was running at between 1.5m and 1.8m barrels a day (bopd) at the end of last year. That's with Opec's de facto leader, Saudi Arabia, operating at or near full tilt. US inventory levels for December were well in advance of expectations, while energy demand in both the US and Europe has been held in check due to an unusually mild winter. Inventories are expected to expand in the near term as the seasonal maintenance programmes for US refineries get under way. And, with new barrels in prospect from the National Iranian Oil Company (NIOC), near-term prospects for the oil price are no better than they were a year ago.
Matters aren't being helped by a perceived slowdown in Chinese economic growth; part of the reason why the US Energy Information Administration (EIA) anticipates that demand growth in 2016 will pull back by around 500,000 barrels from last year's record increase of 1.8m bopd. There are also expectations of increased US dollar strength; another negative factor given the greenback's inverse correlation to the oil price. A research report recently published by Morgan Stanley indicates that because of oil's leverage to the dollar, the price of crude could fall by 10-25 per cent if the US currency gained 5 per cent.
Saudi Arabia's determination to force lower-margin production out of the market has had a limited effect thus far, although it's clear that US output peaked during the second quarter of 2015. At the time of writing, the Baker Hughes Rotary Rig Count for North America stood at 664 - a 64 per cent contraction from the corresponding juncture in 2015. And yet, according to the EIA, by the end of the third quarter of last year, US field production stood at 9.35m barrels a day, or 0.2 per cent in advance of the rate midway through last January. This apparent anomaly, again, is due to improved operational practices, although separate data from the IEA suggests that a decline in US shale output is now well established.
FTSE 350 oil companies have been trimming their sails in anticipation of low prices through the first half of this year - and perhaps beyond. BP (BP.) has just announced plans to axe 4,000 jobs in response to a further plunge in crude prices, while Africa-focused Tullow Oil (TLW) has said that it will slash capital spending by $600m to $1.1bn, as it forgoes exploration/appraisal work in favour of optimising existing assets. Doubtless other FTSE 350 constituents will follow suit during the upcoming results season.
Oil futures will find some support once the market starts to factor in a decline in US shale, but short of any geopolitical disruption it's unlikely that we'll witness an appreciable reduction in surplus production until well into the third quarter. However, the annual rate of oil demand growth, while slowing, should remain well in advance of 1m barrels. So, if we assume that Opec has limited spare capacity, once it becomes clear the market balance is moving towards equilibrium the price of Brent crude could retrace rapidly. For now, though, hair shirts are the order of the day for the FTSE 350 producers.
| NAME | Price (p) | Market cap (£m) | PE (x) | DY (%) | 1-year change (%) | Last IC View |
| BG GROUP | 940 | 32,125 | 13.6 | 2.0 | 9.9 | Bid situation, 928p, 29 Dec 2015 |
| BP | 342 | 62,946 | NA | 7.7 | -16.3 | Hold, 382p, 29 Oct 2015 |
| CAIRN ENERGY | 130 | 746 | NA | 0.0 | -29.1 | Hold, 151p, 18 Aug 2015 |
| NOSTRUM OIL & GAS | 327 | 616 | NA | 5.5 | -28.1 | Hold, 488p, 25 Aug 2015 |
| OPHIR ENERGY | 82 | 582 | NA | 0.0 | -34.9 | Buy, 111p, 14 Aug 2015 |
| ROYAL DUTCH SHELL A (LON) | 1,365 | 54,476 | 10.1 | 8.9 | -35.6 | Buy, 1,692p, 02 Nov 2015 |
| ROYAL DUTCH SHELL B | 1,370 | 33,421 | 74.9 | 9.1 | -36.8 | Buy, 1,692p, 02 Nov 2016 |
| TULLOW OIL | 128 | 1,167 | NA | 0.0 | -65.4 | Hold, 237p, 29 Jul 2015 |
Favourites
One of the main debates you'll find on investor bulletin boards is whether Royal Dutch Shell (RDSB) will be able to maintain its dividend rate in the face of the oil price slump. We've kept faith with the Anglo-Dutch giant as it has reduced cash flow commitments by cancelling a series of legacy projects that no longer make economic sense; management is optimising cash flows as it has been explicit in its determination to provide adequate cover for dividend payments. Although the proposed merger with BG (BG.) is attracting some last-minute resistance, the deal - if successful - will be a major step in the strategic transition of Shell's product mix towards natural gas.
Outsider:
At the third-quarter mark, we commented that "if there was any silver lining from Deepwater Horizon it's that BP was out of the blocks much quicker than its rivals on the cost-cutting front". BP has reduced its capital commitments significantly, while the performance of the downstream segment gives cause for optimism. But a stark fall-away in underlying replacement cost profit will continue to weigh on valuations.
