As Royal Dutch Shell's takeover of BG completes today, it's time to take stock and question the aptness of energy company's forecasts.
Shell has said that the deal with BG will work with oil prices in the low $60s, however a number of analysts have since cut their forecasts for Brent crude.
At the beginning of 2015, the median oil price being used by analysts was $80 per barrel and $85 for 2015 and 2016 respectively. Currently, they're using $55 and $58.
Despite the consequent cuts to energy companies' earnings' estimates, many of the underlying oil stocks remain resilient.
We think this is because most analysts, and investors, continue to believe the oil price will be materially higher in the near future and are prepared to look through current weak earnings.
Last week, Shell recently reported earnings fell 80 per cent to $3.84bn in 2015. And earlier this month, BP said it made a $3.3bn loss in the fourth quarter. On that same day, Exxon Mobil announced its quarterly profit plummeted by 58 per cent.
Current earnings estimates are implicitly assuming a 32 per cent increase in the oil price next year and an impressive 59 per cent increase by 2017, while an oil price 82 per cent higher than today’s is being used to derive longer term earnings forecasts. With such assumptions, it is relatively easy to make a buy case for most oil stocks.
But the world has been over-producing oil every quarter from the beginning of 2014. Meanwhile, the degree of oversupply has risen, rather than fallen despite oil prices weakening.
Specifically, since August 2014 – when oil was last over $100 per barrel – global oil production has risen by 3.6m barrels per day (bpd). Interestingly, during this period the level of US shale oil production rose by just 263,000 bpd.
In fact, the largest contributors to global supply growth over this period have been the Opec nations of Iraq and Saudi Arabia, together with Russia, the US offshore Gulf of Mexico and Asia.
Even if, as the IEA expects, US shale oil production falls by 600,000 barrels per day next year, this needs to be understood in the context of the world currently over-producing oil by 1.6m barrels per day, and where global inventories are at levels not seen for more than two decades.
Read more: Will the Shell-BG deal pay off?
Clearly, the risk is that the oil price continues to stay at current levels, or lower, over the near term.
Oil producers will not cut production due to the economics, while Saudi Arabia is unlikely to initiate production cuts either until it achieves some or all of its strategic aims.
If we are correct, it means the oil price, the most important modelling assumption used by oil analysts, is incorrect. This would mean significant downward revisions to earnings expectations and valuations for the sector.
Equally, it will mean recent mergers and acquisitions and debt issuance, based on budgeted higher oil price assumptions, may not be as economically viable as first thought. A veritable house of cards.