Kapok Capital Newsletter – May 2018

Using capital cycle analysis to understand the crude oil price

By Paul Dufays, Chief Executive, Kapok Capital

Everyone involved in the oil and gas industry has been affected by the slump in the crude oil price which began in late 2014 but which now shows some signs of ending.  Upstream companies and service providers, having grown accustomed to an oil price of over $100/bbl at the peak of the cycle, saw their revenue slashed, and consequently adjusted to this new reality, whether by reducing opex, cancelling or deferring investment, financial restructuring, workforce reduction or some combination of all of these measures. As a result, various oil companies have said they can now survive or even deliver a profit at a crude oil price of $40 to $50/bbl.

The upward trend in the crude oil price of recent months has provided a more supportive basis for oil companies, service providers, investors and advisers alike on which to make investment decisions. However, it raises the question of where the crude oil price will go from here. Will it stay over $60/bbl (or even $70/bbl) in the short to medium term? Will it go even higher? Or is the recent recovery just a temporary phenomenon, with the price poised to fall back?

At Kapok Capital, we gain insight into industry cyclicality by applying capital cycle analysis.  This is an approach espoused by Marathon Asset Management and captured in a collection of their letters to clients, Capital Returns: Investing Through the Capital Cycle. (1)  This approach does not attempt to forecast the demand for goods or services. It takes the view that it is too difficult to predict demand for a service or commodity accurately, and even if it can be predicted accurately, this information is of limited value in predicting the price of a commodity or the fortunes of any particular industry.

Capital cycle analysis instead focuses on forecasting the supply of goods, services or commodities in an industry. This is done by monitoring the pace of capital investment in the industry: the amount/rate at which capital is being allocated to increasing production, as this should give guidance as to whether the supply of goods or services can be expected increase. A useful metric for measuring the rate of investment is to look at the ratio of a company’s or industry’s capital expenditure (capex) to depreciation in any given year.  Depreciation is an accounting measure intended to reflect the level of expenditure required to maintain a company’s capital asset base at its current level.  If the company invests an amount equal to depreciation expense in any given year, then the ratio of capex to depreciation will be exactly 1 and it will be on track to maintain its capital asset base at current levels. If it invests at a higher rate, the capex to depreciation ratio will be greater than one, and its capital asset base will grow. If it invests less than the depreciation expense for that year, then the capex to depreciation ratio is below one, and its capital asset base is shrinking.

The thesis is that for investors, investing at a high point in the capital investment cycle, when investment is at a high level, is likely to result in lower investment returns, for the simple reason that the increasing asset base will result in increased supply, and an increased likelihood that prices and industry profitability will fall.  Conversely, investing at a low point in the capital investment cycle, after substantial cutbacks in investment or industry consolidation, is more likely to result in higher investment returns, as supply is likely to be reduced, which supports higher pricing and improved profitability.

One example given in Capital Returns to illustrate the capital investment cycle and its effects is the mining industry. “Annual global mining production rose in USD terms by 20 per cent annually between 2000 and 2011…[i]n volume terms, iron ore production doubled over the same period. Mining capital expenditure climbed more than fivefold, from around $30bn a year at the turn of the century to peak at over $160bn.” (2) The ratio of miners’ capex to depreciation rose from 1.1x in 2001 to 3x in 2012.  At this point the mining cycle appeared to turn and metals prices fell substantially.  The price of the Blackrock World Mining Trust fell from 818p in April 2011 to below 200p in December 2015: a rough ride for industry investors.

Looking at the oil and gas industry, analysis of this capex to depreciation ratio for some of the largest oil producers reflects a similar pattern, although the cycle turned about three years later.  The graph below reflects the average capex to depreciation ratio for a selection of large oil companies  and the Brent crude oil price for the years 2004 through 2017. In the graph below, the “capex” figure includes both reported capital expenditure as well as exploration expenses.  The “depreciation” figure includes depreciation, amortisation and depletion.

Oil Industry Capex to Depreciation Ratio 2004-2017

We noted three interesting trends in this graph:

  1. During the peak years 2011 to 2014 when the Brent price was at or above $100/bbl, the capex to depreciation ratio remained consistently above 2.0x for this group of companies, indicating a growing supply base.  We all know what happened next…
  2. The ratio of spending to depreciation (the green line) never actually falls below 1.0x, even during the recent trough. Oil is a capital-intensive industry.
  3. The average capex to depreciation ratio in 2004-2010, prior to the big peak, was 1.94x. However, over the last three years (2015-17) the average ratio was 1.25x. This is a materially lower rate of relative investment than during the pre-peak level.

It is this low relative rate of investment during the period 2015 to 2017 that we believe provides the most significant insight into where the crude oil price may go in the medium term.  Oil fields are finite resources and production rates decline naturally over time without new investment. The pace of investment has been reduced drastically over the last three years. There are still some very large offshore oil projects approved during the peak period in 2011-2014 which continue to come onstream, providing support for supply levels. However this pipeline of large oil projects approved prior to 2015 will undoubtedly run out. But when? It depends on our estimate of the length of the project development cycle. If we make a very rough assumption that these large offshore projects take five years to come onstream from final investment decision (FID), then counting forward from late 2014 when the crude price slumped, this pipeline of developments may run out around the end of 2019. From this point global crude oil supply will no longer benefit from these large peak cycle FIDs coming onstream and the effect of recent underinvestment will be felt. US shale oil developments have been able to increase production in response to higher crude prices with a much shorter investment cycle of 8 to 9 months. However, the ability of US shale operations to increase production is not instantaneous and is not unlimited.  At some point it will reach limits (or conditions of increasing expense/scarcity) in terms of availability of capital, appropriately skilled personnel and equipment. The US oil industry will not by itself be able to balance out the natural decline of oil production in the rest of the world together with the end of the pipeline of large oil projects approved before 2015.

So what is the forward outlook for the crude oil price? As to the balance of 2018, we will confess we don’t really know. In the short term the crude oil price is prone to sudden movements based on geopolitical uncertainties and weekly stock data. It has had a sharp run upwards in the course of April likely for this reason:  Donald Trump’s resistance to the Iran nuclear deal creates uncertainty about whether sanctions may be re-imposed and Iranian crude sales curtailed.   However, given the sharp run-up in the price, it is possible that the price may have gotten ahead of itself and will cool off later in 2018.

For those with a medium to long-term outlook, our view is that in 2019-2021 and going forward, the outlook for the crude oil price is quite positive due to the relative under-investment during 2015-2017 as the tail of large projects approved prior to 2015 runs out and US shale and OPEC production increases cannot keep pace with the natural decline of existing oil developments. This should in our view support a Brent crude oil price above $70/bbl during the period 2019-2021 and going forward as the recent under-investment in upstream oil and gas starts to bite.

The oil industry is well-known for being cyclical and the investment and price trends discussed above support this reputation.  That is easy enough to establish in hindsight. However, we believe insight can also be gained into the likely forward path of the oil price by ignoring a lot of the short-term hype around the crude oil price and analysing the industry capital investment cycle and in particular the ratio of capex to depreciation.

Kapok Capital is a corporate finance advisory boutique providing debt and equity fundraising and M&A advice to energy and infrastructure businesses.  Find out more about us at http://www.kapokcapital.com.

This article is for information purposes only and does not constitute investment advice. Any forward-looking statements about the crude oil price or the rate of capital investment are based on assumptions that may prove to be incorrect. Actual prices may vary substantially from the projections stated above.


  1. Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15, ed. Edward Chancellor, Palgrave Macmillan, 2016.
  2. Capital Returns, p. 7.
  3. The group of oil companies selected is ExxonMobil, Royal Dutch Shell, BP, Total, Chevron, Repsol, Statoil, ConocoPhillips, Devon, Occidental, Hess, Anadarko and Apache. We note the capex trend for the largest integrated companies, which have substantial marketing and refining businesses in addition to upstream operations, was roughly the same as for the entire group. Figures were taken from company filings.