At the beginning of this year the median oil price being used by analysts was $80 and $85 for 2015 and 2016 respectively. Currently they are using $55 and $58 – a significant 30% reduction in the most important modelling assumption (resulting unsurprisingly in wholesale negative earnings revisions). However, notwithstanding these significant reductions in earnings estimates, many of the underlying oil stocks (some E&Ps and most Integrateds) have remained resilient. We think this is because most analysts (and investors) continue to believe the oil price will be materially higher in the near future and thus are prepared to “look through” current weak earnings. This is supported by our recent survey of oil price assumptions being used by analysts in their models, details of which are shown in the table below.
Table 1: Median oil price assumptions being used in earnings models
Source: Argonaut, Bloomberg
It is clear from the table above that current earnings estimates (and all other valuation derived arguments) are implicitly assuming a 32% increase in the oil price next year and an impressive 59% increase by 2017, whilst an oil price 82% higher than today’s is being used to derive longer term earnings forecasts. With such assumptions it is relatively easy to make a “buy case” for most oil stocks. Analysts argue these assumptions are rooted in detailed cost and IRR analysis and reflect the oil price required to bring on marginal new fields to satisfy global demand. Whilst theoretically this may be true, we feel reality may be different. Is there really a pressing need to bring on new oil fields in the near term after global integrated companies have sunk $2.6 trillion into upstream capex projects in the last ten years (far above any levels of previous investment) and effectively rebuilding the world’s supply base? We think not. What counts in today’s environment is production costs, and this is critical to understanding the current dynamics in global supply.