5. Consequences of petroleum price cycles on investors
The petroleum price cycles comprising periods of booms and busts pose challenges for all oil and gas companies active in the exploration and production sector. During periods of booms, companies increase activities and investments, commit large exploration programmes and develop new fields, while by contrast they quickly reduce their activities during any bust period, both in exploration and in new projects. Thus, it is estimated that near $1trillion has not been invested by the industry as a result of the 2014-16 bust which should amplify the risk of volatility in the coming years if the demand rises more than anticipated.
First and foremost, price cycles influence the industry’s attitude towards spending on exploration and production and deciding on new projects. There is an argument which says that resource industries should invest counter-cyclically – which is to say, they should invest when prices are low, so as to be able in the future to bring on new production capacity when demand is strong and prices are rising. However the reality is that companies invest pro-cyclically; that is, when prices are high or rising. There are good practical reasons for this. Timing markets is difficult and rising prices provide a clear signal that the market is short of production and may become under-supplied.
Equally importantly, it is when prices are rising that companies have higher profits and therefore the money to invest in new capacity. Higher prices boost their operating margins and increase their retained earnings, but they also provide confidence to those who finance resource companies, stock-market investors and large banks. These groups are much more likely to invest and to lend when commodity prices are high. An inevitable consequence of this pattern of behaviour is that company investment gives momentum to cycles, contributing to a tendency for supply (and prices) to overshoot on the upswing of the cycle and to undershoot on the downswing.
Companies’ operating behaviour is also strongly influenced by the state of the cycle. It tends to be the case that when prices are high producers focus on maximising their output and allow their unit costs to ride up. Moreover, costs of equipment and services rise due to the global growth of the sector activities. This is unavoidable since the inputs to the petroleum sector, such as specialized services, fuel, materials and wages, are often bid up as competition for them intensifies in booming markets. When prices decline, producers’ attention switches to mitigate the fall in their margins by forcing down their costs. This will commonly involve drastic workforce reductions, both in companies and in service firms, as observed during the 2014-16 bust.
Managing the effects of price cyclicality can be challenging for companies. Part of the problem is that companies are dealing with large, lumpy investments and are generally unable to forecast with any precision the scale or duration of price cycles. They have the ability to hedge (lock in) prices for some commodities but this is really only a short-term solution and, anyway, without perfect foresight they are as likely to get the timing of this wrong as right.
For all the above, there is a general tendency in the industry to over-react to price movements. Rising prices commonly lead companies to become over-optimistic about the prospects for their markets and over-invest in new capacity and exploration. Not only does this result in markets becoming badly oversupplied but too often it results in companies, in particular for small and medium enterprises, going into cyclical downswings with too much debt on their balance sheets, causing problems for managers and financial distress to shareholders and lenders. A contrary problem occurs with weak markets and low prices. Managers can become over-pessimistic with regards to price prospects and unduly risk averse with respect to investment. A consequence of this is that when prices do eventually pick up the industry is not able to rapidly respond with sufficient production.