It was supposed to be a quiet day of trade on the ASX. It’s turning out to be anything but. The Aussie oil industry looks set for a major shakeup, with consolidation on the cards.
Greeting investors this morning was news of a potentially massive takeover. Woodside Petroleum [ASX:WPL], Australia’s largest oil producer, made a formal offer of $11.6 billion for Oil Search [ASX:OSH].
As far as mergers go, it’s a potentially seismic shift in Aussie oil. It’s also a sign of the barren landscape the oil industry finds itself in. The Gulf nations still flood the world with excess oil, all in a bid to maintain market share.
As prices have plunged, the effects have devastated smaller and larger producers alike. The only difference is that the big fish have enough of a buffer to gorge on smaller producers.
That’s exactly what’s happening here with Woodside and Oil Search. If this merger went through, it would join the two biggest players in Australian oil at the hip.
Woodside, Oil Search stocks go in opposite direction
At present, Woodside has roughly two and a half times Oil Search’s $10.5 billion market cap. And it has enough spare cash to finance a takeover. Yet convincing investors of the merits of a takeover is slightly more difficult.
Woodside’s share price fell 3.07% by 3:00pm AEST. Stocks were trading at $29.64 apiece. Woodside investors are less enthusiastic about a takeover for one reason. A successful takeover would eat into its vast cash reserves.
Oil Search’s went in the opposite direction, with its stock rising 16.05%. Its shares were trading at $7.81 at 3:00pm. Oil Search’s market cap is now approaching $12 billion, up $1.5 billion for the day. Not a bad morning’s work if you’ve invested in the company.
So why is Woodside interested now? Truth is, the company has been mulling this over for some time. Discussions have taken place dating back to last year. But the timing comes as the pressure of low oil prices takes its toll on the market.
Oil Search’s shares have slumped 30% in the past year amid low prices. Woodside’s have too, but it’s falling from a much larger base than its competitor.
Nothing is set in stone just yet though. Any takeover would require the stamp of approval from the Papua New Guinean government. The PNG government currently owns 10% of Oil Search. It’s not altogether clear how willing they’ll be to accept a merger.
That leaves this potential merger in the ‘wait and see’ category for now.
But we can expect to see more of these proposals in the future, because the outlook for oil remains bleak. To understand the future, we need to see how we got here in the first place.
Supply and demand doesn’t add up in oil markets
Any normal market undergoing a price decline would see supply fall to match that. If prices fall, there’s little point in maintaining high supply. Otherwise, prices either stay flat, or they continue falling.
Yet that’s not what we’re seeing in the oil industry. In fact we’re seeing the exact opposite of this taking place. Oil supply is rising, despite steep falls in prices.
What we should be seeing instead is a tightening of global supply. Cutting back on production would lift prices back to ‘normal’ levels overnight. Why isn’t the industry doing this?
It all has to do with the Organization of the Petroleum Exporting Countries (OPEC).
If you haven’t heard of OPEC, think of it as a cartel that sets production levels and prices. Not every major oil producer is a member of OPEC. Take Russia for instance. But the organization still controls 80% of global oil reserves. And it’s putting up with low prices even as its member nations undergo massive budgetary pressures.
Yet, without OPEC’s hand in this matter, prices would far higher than they are today.
OPEC might argue that rising global demand justifies its strategy. But any rise in demand is down to prices being $115 lower than they were last year. Brent crude oil is trading at US$48.02. WTI crude, meanwhile, is also at a low of US$44.72. Prices are down more than 12% on average from last year.
There’s no sign that OPEC are prepared to let up on production either. OPEC producers had a very busy July, with oil outputs reaching six month highs.
Why is OPEC acting against its own interests?
Like iron ore, oil prices are down because of supply and demand. Similarly, oil prices are falling because of market share driven strategies. Right now, OPEC is waging a war on competitors, both in and outside the industry. It’s doing this for two reasons in particular.
The first is that OPEC desires to maintain and expand its global market share.
By doing this, they’ll come closer to achieving their second aim — ruining the US shale oil industry.
OPEC has already driven out high-cost shale producers. But it hasn’t succeeded, as the shale industry remains afloat.
At the same time, it hopes to nullify the threat of Iranian oil. If the US and Iran agree a nuclear deal, it could open the world to Iranian oil. That would not only increase supply further, but it would directly compete against OPEC’s oil.
Until OPEC crushes its competitors, the oil industry remains in a race to the bottom. What does that mean?
It means that prices will stay low for some time yet. At the same time, we can expect to see more takeovers and mergers, not just in Australia but across the world too.
Contributor, Markets and Money
PS: Oil, like other commodities, is having a rough year. Commodity exporters have shed 5% on the ASX since early June. But the situation could get much worse before it improves.
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