According to Moody’s, continued growth in oil demand will check any precipitous long-term fall in oil prices
Since demand for oil will continue to grow, the recent sharp drop in oil prices is unlikely to be followed by a precipitous long-term fall, according to Moody’s Investors Service. The rating agency hasn’t changed the price assumptions for oil it uses in its ratings analysis, it says in its report ‘Drilling and Services Companies Most Vulnerable to Tumbling Oil Prices’.
In September, Moody’s announced that it had lowered the Brent crude price assumptions used for rating purposes to $90/barrel (bbl) through 2015 – a $5/bbl drop from the ratings agency’s previous assumptions for 2015. Moody’s also reduced its price assumptions for WTI crude to $85/bbl from $90 through 2015.
Despite growing supply, particularly in the US, longer-term pricing should remain above $80 a barrel, given growth in global demand. That said, Moody’s cautions that prices could easily dip into the $70s/bbl range in the next several months.
Oil prices dropped during the summer of 2014, reflecting slower economic growth in some of the world’s major economies, a strengthened US dollar and growing non-OPEC supply. Concerns about a slowdown in the pace of growth in China, and weaker economic conditions in Brazil, Russia and much of Europe – including Germany and France – point to a slight retreat in crude demand as well.
Moody’s Managing Director Steve Wood says it is hardly shocking that oil prices have weakened in the face of growing supply.
“The large movements in oil prices in 1973, 1979, 1986 and 1990 were all in response to supply shocks. It wasn’t until about 10 years ago that we saw prices rise because of spiking demand. In that sense, we’ve gone back to the future – supply is driving oil prices. In other words, excessive supply is driving prices down.”
Wood attributes the sharp drop in mid-October to expectations of weaker demand growth in China and Europe at the same time that Saudi Arabia has threatened to defend market share rather than acting as OPEC’s – and the world’s – swing producer. The other significant factor is the strengthening US dollar. Because oil is denominated in dollars, a stronger dollar leads to lower oil prices.
Moody’s research note noted that lower prices will hurt Exploration and Production (E&P) companies’ revenues immediately, with most of the drop falling straight to the bottom line because of their high operating leverage.
The impact of lower oil prices in the oil and gas sector will be most felt by producers, including integrated oil companies and national oil companies. Some of the drop will be mitigated by hedges and offset by lower operating costs.
If lower prices persist and E&P companies reduce capital spending and their demand for services, drilling and oilfield services companies will definitely come under pressure.
“Drillers and service companies will feel the most pain as producers react quickly to cut their costs,” says Wood. “Even if we don’t see a dramatic drop in rig counts or activity, we would expect to see pushback on prices and day-rates that service companies are able to charge producers. Drillers and service companies without contracts or that work on a ‘call out’ basis will be hurt the most.”
Wood points out that if lower oil prices persist, production growth could slow in North America. He continues: “Shale wells typically have high initial decline rates, so a slowdown in activity would reduce throughput volumes for mid-stream companies. Gathering and processing companies with percent of proceeds contracts will see lower revenue. Retail fuel prices tend to be sticky on the way down, so refiners’ margins will benefit in the immediate term until pump prices catch up with lower feedstock costs.”