Shares of the UK’s oil producers have had a memorable couple of weeks. Many of the larger oil companies, such as BP Plc (LSE: BP) and Royal Dutch Shell, have gone from nursing double digit losses to for the year to date, to either break even or modestly positive returns for the period. Key to this change in fortunes has been the much vaunted prospect of an agreement between Saudi Arabia and Russia on oil supply.
Initially it seemed as if Saudi Arabia was willing to resume its role as swing producer, so long as Russia was willing to share the burden. However, in recent days, such hopes have been all but dashed upon the rocks of reality as the agreement that has materialised is one that seeks to freeze supply to the market, from participating countries, at January’s record high levels.
Nevertheless, oil and gas sector investors have been undeterred by the underwhelming nature of the deal and have kept a steady bid on oil shares since the announcement.
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What does this mean for you?
It is tempting to believe that this could be the beginning of a coordinated effort at the international level to support prices, one that could eventually bring about an end to the pain experienced by shareholders in recent quarters.
Such a belief would be delusional. It’s looking as if the recent agreement agreement will be no panacea for the sector, but particularly for BP.
Despite the best efforts of negotiators, Iran only participates in the process as an observer. After being locked out of international oil markets for four years, the middle-east nation has made no commitment to delay the rate at which it’s bringing its own production back online.
This could see oil supply increase by as much as 3.5m barrels per day over the next 12–18 months, an amount that is equivalent to roughly 3% of current global supply.
In addition, US shale producers remain a wild card in the evolving oil price equation. What do these organisations do in the event that the Saudi / Russia agreement manages to place a floor under prices, or if it helps to drive them higher?
Common sense would suggest that US shale comes back into action and/or increases production to exploit improving price conditions. In short, if the agreement holds, then it seems that the net effect on prices would be one that prevents significant further downside but does little to improve upon the current picture.
BP shareholders beware
BP shareholders need to consider something else, in addition to the above. The company has a noteworthy shareholding in the Russian state oil producer Rosneft, from which it receives substantial dividends.
The dividend that BP receives from Rosneft is, in most periods, equivalent to 15% of BP’s total replacement cost profit (underlying earnings). However, the dividend is dependent upon Rosneft’s operational performance.
This is incredibly important for BP in an environment where its entire upstream business is making a pre-tax loss and the improvement in downstream is proving insufficient enough to offset that loss. If oil prices were to deteriorate further from here, while Rosneft remains limited in terms of how much oil it can produce due to the Saudi Russia agreement, then this dividend could be materially impacted.
The upshot is that, because of the recent agreement, BP may suffer disproportionately to the rest of the sector from any further deterioration in market conditions. BP’s shares are low, but they can still go lower.
