Schlumberger: Oil Follows Stocks

The crude oil market is focused on only one fundamental factor right now: global oil demand.

According to the latest Short-term Energy Outlook (STEO) from the US Energy Information Administration (EIA), developed world oil demand is projected to decline a total of 2.2 million barrels a day (bbl/d) between 2007 and the end of 2009, with the majority of that drop coming from the US.

Economic data from the US was already looking bad in the first half of the year. As the credit crunch worsened this fall, the slump appears to have deepened, and crude has been in a tailspin ever since.

Although developing world economies may be slowing, oil consumption is still rising at an impressive pace. The EIA’s latest report shows total developing world demand jumping by a total of 2.3 million bbl/d in 2008 and 2009; that means total global oil demand will actually rise by about 100,000 bbl/d over these two years. While growth in total world oil demand will remain positive, the rate of growth will be the slowest since 1993.

This maniacal focus on demand is also the reason that crude oil has been almost perfectly correlated with moves in the S&P 500; the broader market is also in the process of pricing in the implications of the recession in the US. This correlation between stocks and oil will likely continue for some time. 

Looking into 2009, I continue to see oil supply emerging as a more important issue. Yesterday, Saudi Arabia announced the cancellation of a contract with Italian engineering and construction giant Saipem for the development of the Manifa oil field. This project was slated to add as much as 900,000 barrels/d to the Kingdom’s production capacity by some time in 2011. The cancellation of the contract was part of the Saudis recent decision to review all of their existing planned oilfield developments.

Although it appears Saudi Arabia is mainly trying to negotiate a lower price for some of these deals, the cancellation raises valid concerns that planned expansion of production won’t come online as scheduled.

A similar process is underway globally. According to the International Energy Agency’s (IEA) 2008 World Energy Outlook, the world will need to spend more than USD1 trillion annually between now and 2030 to meet rising oil demand from fast-growing developing nations. But with oil hovering around USD50 a barrel, spending at that level is highly unlikely to occur; even in Saudi Arabia, one of the world’s lowest-cost producers, projects are being reviewed and delayed. 

In the company’s October conference call, Schlumberger (NYSE: SLB) suggested that if oil prices remain depressed, drilling activity would begin to slow. It appears we’re now seeing that slowdown.

This is bad for Schlumberger’s business in the short term. The company is the premier global oil services firm and has its hands in the most promising projects worldwide. But if spending continues to slow, that spells a decline in demand for the company’s high-tech services.

Longer term, the current depressed prices are clearly sowing the seeds of the next oil bull market. Schlumberger has long contended that analysts were underestimating the rate of production decline from mature fields globally. Recent data from the IEA seems to back up that view; the longer prices remain depressed and activity subdued, the faster production will decline. And new sources of oil that could have come online in 2010 or 2011 now look likely to be delayed. The end result: When global oil demand reaccelerates it will be harder than ever to produce the oil needed to meet demand.

Trading at decade-low valuations, Schlumberger’s stock appears to be pricing in a great deal of bad news about oil and declining activity levels. That said, in the short term, the stock will continue to follow crude oil prices. With economic data deteriorating, there’s more short-term downside risk to crude prices. And with crude prices where they are today, there’s likely to be more news of major project cancellations and delays globally.

Schlumberger’s long-term story remains intact, but it’s prudent to take our losses and sell out of the stock for now. We’ll reexamine the story when we see signs of stabilization in the global economy. Sell Schlumberger.

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