oil buyer, or oil seller, that is the question

Back in 2012, I argued that value of an oil producing business depends upon two key factors: oil reserves and oil prices. While I wrote about the significance of being realistic about oil reserves, I did not much deal with oil prices as they are not within anybody's control.

Alas, we are left to deal with it in these times. With oil prices falling just like that, there are at least two groups who are affected. Those who produce oil, and those who consume oil. There is no prize for guessing in the current times who you would like to be. 

Naturally, oil producing businesses have been hit and oh boy. At less than $60 per barrel, suddenly the time is to be the buyer of oil rather than the seller. I wonder why then the stock buyers go gaga over rising stock markets rather than falling. That post is for another time though, let's come back to our current story line. 

Oil sellers

The right thing to do for the oil producers now is to cut back on production and let market prices of oil rise to the levels required to give them the required rate of return. Unfortunately, producers with lower financial flexibility (having high debt, and low debt capacity) should panic, and have higher chances of bankruptcy. These firms might not have time to wait for the prices to rise. A sorry situation reflecting probably poor managerial skills (financing decisions). Those who have the financial flexibility would be able to cut the production, and wait for the prices to correct. There is no time frame in this respect as the prices tend to be unpredictable, and to a large extent not controllable. 

Then there is another class of oil producers whose dynamics are decided by the state rather than the owners. Take the example of ONGC whose hands are tied regarding both production and pricing. Firms like this will have no option, but to rely on the state's (rather than the firm's) economic considerations. History suggests that the state has not taken the right decisions on behalf of the owners. Therefore, ONGC has not performed the way it would have if it were a private firm.

Oil buyers

The story is quite different for the oil buyers. Businesses who consume oil in large quantities as their raw material, and having pricing power on their finished products, are likely to be key beneficiaries of low oil prices. They should be able to increase their operating margins other things being equal. Businesses selling less discretionary products to the consumers are best placed to increase their value. 

Investors

Investors will be well placed to buy stocks of oil buyers having pricing power. And those interested in buying stocks of oil sellers should consider buying those who have low debt, large reserves, and control over the timing of production. Privately owned or publicly listed oil producers are better placed in this category rather than the state owned.

Needless to say that the price of the stock compared to its value should be the primary consideration before making any buy decision.