The oil price has fallen dramatically since last summer. This has meant difficult times for the oil producers, including companies such as BP (LSE: BP) and Royal Dutch Shell (LSE: RDSB).
But with the price of gasoline falling so much, surely this means that energy companies are contrarian buys? Surely when we saw the oil price tick upwards over the past month, this means it is recovering?
Let’s zoom out. As the global economy, particularly emerging markets such as China, have grown rapidly over the past decade, they have pushed commodity prices higher.
This is about supply and demand, but it’s also about momentum
Because hydrocarbons were so highly valued, there been a rush of investment in exploration and production capacity. New oil wells have been drilled, and rigs built, across the furthest reaches of the world.
What’s more, people have been buying more fuel-efficient cars, and there has been huge investment in technologies such as hybrid, electric and fuel cell vehicles.
So supply has been steadily increasing, and demand has been falling, and the world now has too much oil. Oil prices have begun a downtrend; and I don’t think that this fall will just last a few months, before bouncing back.
You see, commodity markets are not just about supply and demand. They are about momentum. That’s why I think this new era of low oil prices could last another decade. All those wells that have been drilled won’t suddenly run dry, and production won’t suddenly end.
Commodities production is not only continuing, but more capacity is being built. Just this last month BP announced a $12 billion investment to construct gas fields along the West Nile region of Egypt. Meanwhile, shale oil production is still ramping up, not falling.
Meanwhile, petrol forecourt prices have decreased, but not by so much. Consumers are still buying fuel-efficient cars and firms are investing in novel technologies such as electric vehicles. Demand is unlikely to increase quickly.
This is the oil industry’s ‘new normal’
This is why I think that the oil price could fall even further over the next few years. And I think companies like BP and Shell realise this. They are now adjusting to the new reality of low commodity prices.
This will mean that investment will decrease, and margins and profits will fall. So will oil firm valuations. But production and revenues may not fall as much as you think, and the industry will still be one of this country’s leading employers.
If you check the fundamentals, you can see that earnings are already tumbling, which means the oil companies now look expensive; this is definitely not the time to buy. For example, BP is on a 2015 P/E ratio of 22, falling to 14 in 2016. And Shell is on a P/E ratio of 20, falling to 13 the following year. I suspect that the dividend yields will also trend downwards as these businesses seek to conserve cash.
However, we need to see this in perspective. This doesn’t mean the end of the oil industry, but just adjustment to a new reality.