The price of Brent crude oil fell below $57 per barrel on Tuesday, following the lifting of economic sanctions on Iran. Oil exports from Iran could rise as much as 60% by the end of this year, which would exacerbate the oversupply situation in the global oil market. Combined with slowing demand growth from Europe and Asia, this will likely reinforce the downward pressure on the oil price.
Goldman Sachs currently expects Brent crude oil prices to average $58 in 2015, and $62 for 2016.
Shares in Royal Dutch Shell (LSE: RDSA) (LSE: RDSB) and BP (LSE: BP) may have fallen 26% and 14%, respectively, over the past year; but the falls seem limited in comparison to the impact that lower oil prices have had on their earnings. Instead, investors’ confidence with the oil majors’ abilities to sustain their high dividend yields have acted as a support for their share prices.
Shell’s sizeable downstream operations offers it a significant buffer against lower oil prices, as refining margins tend to expand when crude oil prices fall. This is because the oil that refiners use becomes cheaper, whilst the price of its output of refined petroleum products are less sensitive to changes in crude oil prices.
The benefit to Shell’s downstream business is particularly noticeable, because of its heavy exposure in Europe, which has seen refining margins expand much more significantly than in North America. Nevertheless, Shell’s underlying earnings fell 56% to $3.2 billion in the first quarter, as weaker upstream earnings outweighed the gains from downstream.
BP, on the other hand, has a smaller downstream business to fall back on when oil prices fall. For every dollar the price of Brent crude oil falls by, BP’s annual upstream replacement cost operating profit falls by about $300 million.
However, far greater concerns are with the high breakeven costs of current upstream developments. Shell remains committed to its costly Artic exploration project, which has a breakeven cost of around $100 per barrel. BP is using a breakeven target of $80 per barrel in deciding new investment projects, whilst Shell is said to be using $70.
Tullow Oil
With oil prices staying low for longer, Tullow Oil (LSE: TLW) is a more attractive investment. The low-cost Africa-focused oil producer has a cash operating cost of just $18.6 per barrel of oil.
Hedging has lessened the impact of falling oil prices on Tullow’s earnings. In 2015, 60% of its share of oil sales had been hedged with an average floor price of around $86 per barrel. But, for 2016 and 2017. only 40% and 20% of production has been hedged.
Shares in Tullow Oil may not have bottomed yet, but the low point should not be far off. On a total cost basis, Tullow’s average production costs are about $38, which makes it one of the lowest cost producers in the sector.
If Tullow falls much further from here, its assets in low cost producing regions would make it a very attractive acquisition target. Its valuation of $19 per barrel for its proven and probable reserves is modestly higher than the sector average, but the quality of its assets is also higher.
Potential suitors go beyond Royal Dutch Shell and BP, with Marathon, Statoil and Total being possible buyers. But, even if Tullow does not find itself a buyer; its relatively modest debt levels and robust cash generation will mean it can fund continued investments in production growth.