Heres a brain teaser for you: if BP (LSE: BP) (NYSE: BP.US) produces oil, and the price of oil goes down, what happens to BPs bottom line? Stumped? Its a tough question but the answer is that it decreases.
BP investors understand this risk. They know that if the price of oil falls significantly the value of their investment will go down. So what if the price of oil goes down significantly, and stays down?
For the answer, look no further than the companys accounts. Youll find a statement warning that an extended period of depressed oil prices could have the affect of hurting the companys cash flow, profit and ability to maintain its long-term investment programme. That, in turn, BP says, will have a consequent effect on the oil producers growth rate, and may also impact shareholder returns.
The assumption
Its important to know where BP expects the price of oil to settle, or at least the price of oil it is comfortable with. This is the price that BP will make investment decisions around, and the price it will use to forecast its earnings. According to its latest annual report, BP is factoring in an oil price of $100 per barrel. Thats the price the company is factoring in as it brings new upstream projects on stream.
It was great when the price of oil was trading at $115 per barrel in June. BPs stock price was also trading at a high altitude at that point. Since then both West Texas Intermediate and Brent Crude prices have fallen more than 20 per cent, and officially into bear market territory.
The problem
The sticky issue is that analysts cant see an near term end to the falling prices. There are several main reasons for this. There has been a sharp increase in North American oil production. That has coincided with sustained output from Libya and Iraq (despite the recent violence). And finally were seeing weaker demand from Europe and China (Saudi Arabia recently cut prices for November exports to Asia). The potential for further economic growth hurdles in France and Germany are particularly concerning with regard to Europe.
Supply side solutions?
What about OPEC? Wont the governing oil body cut back on production as the price falls? Well figures released last week show OPEC actually lifted output by 402,000 barrels a day in September. The picture for oil bulls doesnt get much prettier looking at North America, either. Its this Fools understand that shale oil is set to boost US crude output to the most in more than three decades.
Its not crude, its just rude
Bullish oil traders may have received a rude shock last week when John Kilduff, partner at Again Capital in New York, told Bloomberg that, The dynamic has changed. Commodities are all about supply and demand and both are negative at the moment. In other words, as explained above, this is not just a demand problem, much like iron ore, the world is simply struggling to absorb current supplies of crude. Worse still, its a problem thats not going away and markets know it.
West Texas Intermediate for November settlement is now trading at around $85 per barrel on the New York Mercantile Exchange. The futures market hasnt seen a price like that since December 2012.
Something needs to change
If the price of oil stays in the high 80s or continues to fall, you may find BP adjusting its books, or its investment plans. Why do I say that? Well, BP has already indicated in its accounts that any sustained change in the price of oil could mean various investments or other decisions need to be reviewed. It also concedes that assets may be impaired, and the viability of some of it projects may be affected.
BP will be hoping that there is a decrease in the world-wide quantity supplied of oil because the demand curve is almost certainly shifting further to the left. Indeed, the IMF recently reduced its global growth forecast for this year and next.
BP management would know that you know that there is a direct relationship between the price of oil and BPs profits. I think management would prefer though that you didnt know what the markets forecasting that price of oil to do in the medium term.
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David Taylor has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
