Oil prices are coming down from recent peak and in my view should trade in a US$100bbl -US$120bbl range. However, oil stock prices are down far more and look to be pricing the elusive demand destruction sought to eventually curb oil prices. I ran a price sensitivity on Chevron, one the best performing oil majors, to gauge how bad it could get for oil stocks.
The conclusion is that equity prices, for Chevron and many larger oil producers, are incorporating a US$70bbl oil assumption forward. Which does not seem likely. In Chart 1 you can see Chevrons price target (5x EV/EBITDA historical average) on the current oil price outlook. Next to this the price target (same 5x multiple) on US$70bbl. The stock would have a 12% downside into YE23.
In Chart 2 I show the EBITDA differences on the same Oil price assumptions. Note that at these levels Chevron and most oil companies can produce high free cash flow, dividends and share buybacks.
The current oil price forecast curve of US$120bbl in YE22, US$125bbl in YE23 and US$90bbl going forward is based on three key assumptions.
- Russian sanctions continue and effectively eliminate about 2% of global supply. Would a cease fire change this? I doubt it. It’s more likely that Russian oil, gas, fertilizers, metals etc. do not come back to the market until there is a full Ukraine resolution that includes reparations. Russian needs to find ways to export its commodities to nations that do not abide by sanctions like China and India. However, the global payment, insurance, logistics systems do, and few want to take sanction risk or reputation risk in assisting Russia. This self-sanctioning is likely to continue.
- Capacity expansion is close to zero. Oil wells/fields have a depletion rate of 2% to 5% (Shale higher) and thus the sector needs to invest in E&P (exploration and production) to keep current production levels. Given the de-carbonatization drive its highly unlikely companies (focused on shareholder returns) invest in oil production net expansion. Many are focused on renewable energy, going green, reducing co2 emissions. The world should not count on higher oil production from the private sector.
- OPEC is the swing producer, looking to balance the market but keep price high. These nations need another 30yrs to restructure their oil dependent economies.
Hence, in my view, Oil prices should remain elevated. Only a sharp reduction in demand, in consumption, can lead to a price drop. We have seen this many times, recessions, deep ones, lead to significant oil price declines but have been short lived. During the height of the pandemic oil went hit zero. In the YE08/09 great recession oil averaged US$20bbl from a US$140bbl peak. At other times GDP has little to do with it, as in YE14 when OPEC increased production to drive out US Shale.
Chart 3 shows variation in Oil prices (average price) from 1983 to present vs the Global GDP growth. There is a clear correlation, most of the time. Oil price fall sharply in deep global recession.
Chart 4 shows the YE average price of Oil vs Global GDP growth. Similar conclusion, deep recession cause price destruction.
From a long-term perspective oil is a business in decline, like coal, and the oil complex is fully aware of this and should manage supply with a gradual decline. At the same time cost inflation, environmental regulation, and social push back to expanding oil production (refineries, shipping tankers, gas stations etc.) makes it a much more capital intensive and long cycle business facing a declining demand scenario.