The decline in the price of oil has dominated the news over the last few months. In short, there's a complex set of factors around the global supply and demand imbalance we're encountering, which is being further exacerbated by OPEC led by Saudi Arabia taking steps to protect their market share. The consumer benefits from this imbalance through cheaper refined petroleum products such as heating oil and gasoline. Oil is trading at about a 50% reduction of where it's recently been. But what does it mean for related businesses that support the industry?
Obviously no one knows where the price of oil is going to go but don't be surprised if prices trend lower over the coming months. As supply and demand begin to come back in balance, which may occur later this year, the price should find a bottom and then modestly increase. One thing we can be assured is that there will be volatility throughout this period.
On the demand side cheaper prices for petroleum and related products globally should benefit consumers and result in an increased consumption of goods. And on the supply side, a reduction in U.S. drilling activity for the higher marginal costs oil wells will gradually reduce supply growth.
In the U.S. market, we've seen oil & gas exploration and production companies reduce their budgets and capital spending. First to fall victim has been higher priced drilling activities. These are the higher marginal cost wells that are being drilled in various areas such as the Bakken and Permian basins. It's a simple equation - when the cost of oil is high you can expand production by drilling the more expensive wells required to produce oil difficult to access. When prices slide, such as they are now, it's more economical for companies to limit production growth by focusing on lower cost drilling.
This is causing a ripple effect in the U.S. oil & gas sector with drilling rig activity being reduced, related business slowing down and pricing pressure being placed on the services and products these companies provide. With the amount of related drilling being reduced, support services to the sector are also being impacted.
If they haven't done so already, it's time for prudent companies to batten down the hatches and prepare to weather the storm as it migrates through the industry. On the other hand there will also be poorly capitalized companies and those that expanded at the peak who will be faced with challenges to survive.
On a positive side, volatility creates opportunity. There will be panicky sellers - those that have a more short term, less sophisticated view and desperate sellers (i.e. those who need to panic). At the same time there are more sophisticated players that are beginning to bargain hunt with a more long term view. As a result you can expect to see consolidation and related M&A activity.
Mike Lorusso is Group Head and Managing Director for CIT Corporate Finance,
Energy. In this capacity, he is responsible for overseeing all financing activities within the energy sector of CIT. Lorusso holds FINRA series 7, 29 and 63 licenses. He received a bachelor's degree in engineering from Duke University and an MBA from Fairleigh Dickinson University.
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