I am now used to the barrage of news reporting about the current condition of oil price. For the last few weeks, this topic has been featured in the Economist, CNN, businessweek, bloomberg, blogosphere, you name it. However, I don’t see many people cover it in connection to Indonesia investment landscape. In this post, I will try to put together my back-of-the-envelope thinking. Hopefully, it will stimulate further thoughts of yours. šŸ™‚

Most of the news that we see everyday are not really important enough to pay attention to. You can miss them and it won’t kill your investment portfolio. Some of the examples are news such as “Foreign are buying, IHSG up 80 points” and “Market is out of gas, correction is due.” A lot of this kind of news are the type that the market wants to go up, therefore it is going up type of news. It sounds smart, but there is no meaningful content. Blame it on the media which cares about the excitement to generate more readership. Sometimes I find it amusing that people like to give the market a personality. It seems that the market, which is actually an index of group of stocks, has life by itself. However, the dropping of the oil price is not one of those news. It has some implications to how business will perform. Anyway, it’s just an interlude.

The background
Back to the oil. It is quite remarkable that oil has dropped from $100ish to below $70 now. Oil is the most traded commodity in the world. Its drop has a significant impact. After all, oil contributes to fulfill the largest portion of our energy needs. From our daily commutes to the yearly vacation, oil supplies the energy needed for those activities. Oil price significantly impacts our cost of living. Unlike other energy sources, oil is very close to the end-user. Transportation is the largest user of oil; that means cars, trucks, planes. At least, it affects our commuting and the logistics cost of our needs (be it food, plastic, electronic, etc)

OPEC is a legalized cartel. It has 12 members that regularly come together and try to control the oil price by adjusting the production between its members. I use the word “try”, because in the recent times, its effort has been less effective. Another important piece of information is that most of the members require more than $75 to balance their finances; keep this fact in mind. So, right now, most members of OPEC areĀ in pain right now.

So, why is the drop in oil price? And why does OPEC not try to support the price by decreasing the oil supply? To understand this, it is very important to bring the shale gas into picture. The shale gas revolution in US has changed many traditional assumption regarding the oil price dynamics. Shale gas not only changes oil price dynamics, it also affects other commodities, chiefly coal. I have discussed the effect on coal in my previous post. Anyway, the abundance of shale gas (and also sand oil) has fulfilled many demand that would otherwise needs to be fulfilled by oil. As the result, there is pressure on the OPEC’s market share. However, shale gas is not cheap, a lot of the shale gas company will not be profitable.

Previously, the existence of cartel (which is usually not legal) has helped OPEC members to enjoy a secure source of income. For so long these countries are dependent on the artificially high price of oil to support their countries’ budget. Without the cartel, probably the average price of oil will not stay that high. For a long period of time, the cartel offers the protection because there is no real substitute. With shale coming into the picture, the dynamic will not be the same. Shale gas is revolutionary. I will not elaborate it here. However, OPEC decision not to cut the production (which is not their usual course of action in the past) shows that it realizes that it will lose market share if it does so. The competition is real.

How low can it go?
According to this chart, at $50, half of the oil project in the world will be unprofitable. This is a very rough view. A lot of people think that because most of the OPEC members require more than $75 to balance their books, oil price is unlikely go further down. However, this is to underestimate the number of options that is available to them.Ā SomeĀ shale gas companies are still profitable as long as the price is above $40. Furthermore, the demand for oil is not going strong by a lot (even though China is starting to buy more for its reserve, there are only so much you can buy). So even from the peak we have seen oil price going down a lot, it is very likely that it will drop below $60.

Implication

Oil and Gas
There are some sectors in IHSG that will be more or less affected by the weak oil price. The first obvious sector is the oil and gas industry. This is even more true for companies that operate in offshore sector. I used to be a bull for offshore company such as WINS. However, weak oil price means spending on offshore will be less. Some would argue that the bunker rate will be cheaper and most of the offshore projects in Indonesia areĀ in exploration. My gut feeling is that there will be more downside for the offshore companies than the upside. One needs to also consider that the project with SKK Migas has been stagnant for a while and there is not many new projects. It would take a while for the vessel utilization to pick up again. The good thing about company such as WINS is that its management realizes that the market will not be that good this year and itĀ appropriately turns to be less aggressive. I still believe in the company’s good governance. The same can’t be said of its close competitor, which has increased its debt to finance more ship. LEAD will have more room to fall than WINS.

Another interesting company that caught my attention is ELSA. However, due to the valuation and my still limited understanding of the business, I am still hesitating to establish any view on it.

Palm Oil
In 2012, I said that coal and palm oil will go lower. Well, when it comes to prediction, it is hard to get both the thesis and the timing right. I was right on coal price going down, but on palm oil, I have to say that I obtain the privilege of being wrong for two years now. Feels like idiot, but that is the reality of investment world. It is not enough to get the price right only, the timing also matters.

Anyway, what went wrong in my analysis of palm oil? I was discounting the biodiesel factor. When palm oil price goes down, if it goes down far enough, it can be converted into biodiesel. That means that the floor of palm oil price is supported by the oil price. My thesis that the oversupplying of palm oil will cause the drop of palm oil is still valid. However, with the weakening of oil price, there is no more assurance and safety that the price will stay high. The safety net is gone. If you are not a disciplined company such as AALI, then your profitability will be gone. One can hardly understand the trouble that Sinar Mas’ subsidiary Golden-Agri is going through right now. With the possibility of drop in price, its trouble will not be over soon.

 

In the sectors that I cover, I think those two will be impacted by the weakening of the oil price. Of course there will be sector that is helped by the the cheap energy price. Since most of our oil consumption is subsidized, I would think that the cheap oil price is more helpful toward the country’s budget rather than the companies’. Furthermore, as I have argued in my previous post, that we are in the period of slowing down. There are not many interesting investment ideas as valuation is not that attractive. I would probably take a look at the market again when it is hovering around 4,000. I sometimes wonder how the analyst comes up with their bullish case of 6,000. I don’t think many investors have adjust the risk free rate yet (especially after BI rate increase recently). It is more likely that the BI rate will go up than down in the next 24 months. Just like what Arnold Van Den Berg said, if we don’t adjust our multiple, the market will do it for us. I think we are observing what Howard Marks described as “the race to the bottom.”

Thanks for reading this long post. Would love to hear your thoughts.

Disclaimer: I own position in WINS

Further Reading:
http://euanmearns.com/peak-oil-in-the-rest-of-the-world/
http://www.vox.com/2014/11/28/7302827/oil-prices-opec