Business

The game theory of energy prices

THERE is a view floating around capital markets that OPEC's failure to restrict supply is a principal driver of plunging energy prices. When one thinks about OPEC, one is really focused on Saudi Arabia. The storyline here goes that the Saudis are happy to drive oil prices sharply lower long enough to cause damage to the US energy sector.

This sector has borrowed heavily to finance its exploration and production activity, and a period of sharply lower energy prices will impair the debt-servicing capabilities of these companies. The waterfall of events in this scenario is dividend cuts, the cancellation of projects in development, slashed capital expenditure budgets, and then finally, a credit event somewhere among the weaker players in the space. If you subscribe to this line of thinking, a credit event wherein one of the oil exploration and production companies defaults on its debt obligation sparks capitulation within the energy sector, forcing further a decline in share prices.

It will also impair the willingness of management to invest in new projects, as the threat of insolvency forces a husbanding of resources. The net effect of all of this is restraint in the growth of supply. Once the credit event occurs and capitulation follows, a cut in Saudi production returns crude prices to $60-$70 per barrel level.

To be fair, energy companies have begun the process of cutting dividends, mothballing projects and cutting capital expenditures.

A recent article from Reuters casts light on the shape of things to come: the dozen companies they examined revealed planned capital expenditure reductions of much as 50 per cent for smaller operators and 20 per cent for the larger players.

The sample size is not large but it does align with other reports I have seen forecasting global declines in capital expenditure of 20 per cent.

* Jonathan Dobbin (Jonathan. Dobbin@barclays.com) is head of wealth and investment management NI at Barclays and can be contacted on 90882925. Investing in shares is not for everyone. Their value can fall and you can get back less than you invest. If you are unsure, you should seek independent advice.