How Oil Price Movement Could Impact Caterpillar’s Stock

Caterpillar’s (NYSE:CAT) Energy & Transportation segment provides customers with reciprocating engines, turbines, diesel-electric locomotives, integrated systems and solutions, and related parts. It caters to a wide variety of industries such as oil and gas, power generation, industrial, marine applications and rail related businesses.  After its Resource Industries business tanked due to the decline in mining commodity prices and customers’ capital expenditure cutbacks, Caterpillar’s Energy & Transportation segment became the most valuable segment for the company, contributing more than 43% to total revenues from its equipment businesses.

Sales to the oil and gas industry account for around a third of Caterpillar’s Energy & Transportation revenues. The industry has lately been suffering from the decline in oil prices, which has led to a slowdown in Caterpillar’s Energy & Transportation segment. In the fourth quarter of 2014, Caterpillar reported flat revenues for the segment and  forecast a 10-15% decline in revenues for the full year 2015. In this article, we take a look at how two extreme scenarios for long-term crude oil prices could impact the company’s valuation.

See our complete analysis of CAT here

Base Case

After falling sharply by more than 60% in a short period of slightly over six months, oil prices have risen by over 33% from their lows over the past few months. In hindsight, the sharp decline in oil prices makes sense because of slowing demand growth and surging tight oil production in the U.S. We currently expect oil prices (Brent) to average around $75 per barrel for this year, below the global marginal cost of production due to the current oversupply scenario, and increase gradually towards the $85 per barrel mark over the next two years, as the supply becomes tighter due to the recent cutbacks in capital spending by almost all major oil companies and the growth in demand picks up to more normalized levels. These expectations form the base of our $85 price estimate for Caterpillar, with the Global Energy and Transportation equipment market size rising to over $290 billion by the end of our forecast period through 2021.

V-Shaped Oil Price Recovery

There is a possibility of a much sharper, V-shaped recovery in global oil prices if the growth in demand for oil products picks up significantly on the back of lower oil prices or increased economic activity in China. Oil production could also decline because of a sharp and sustained slowdown in drilling activity. The U.S. EIA reports that oil production from the seven major U.S. shale plays is expected to fall by a total of 86,000 barrels a day in June, with production from the prolific Eagle Ford and Bakken shales taking the largest cuts. ^[1] If the cuts continue going forward, it could help to bolster oil prices. Additionally, if the OPEC, which accounts for about a third of global crude oil output, decides to change its current stance and reduces its production, this would also have a very positive impact on oil prices, providing significant tailwinds for oilfield services stocks. If oil prices see a V-shaped recovery, rising to levels of $90 per barrel by next year, which is at the higher end of Caterpillar’s oil and gas industry customer’s sustainable levels of production, this would incentivize them to bolster their exploration and production spends, and undertake more expensive and challenging plays. This would effectively translate into higher demand for equipment such as turbines and reciprocating engines, leading to a rise in Global Energy and Transportation equipment market size. If the market size increases to $350 billion by 2021, assuming that it continues to rise at its average historic growth rate post-recovery, there could be a 10% upside in Caterpillar’s price.

Sustained Decline in Oil Prices

On the other hand, if OPEC maintains its current stance and the growth in demand for crude oil does not pick up because of a continued slowdown in economic activity in China — the world’s second largest oil consuming nation and the key driver of demand growth over the past few years – or because of a rapid increase in the penetration of alternative fuels due to advancements in biofuels or fuel cell technologies, the recent decline in oil prices could sustain for a much longer period. In addition, the expected service cost deflation, which would reduce the average cost structure of the oil industry, could also result in a more robust non-OPEC supply growth despite the slump in oil prices. If this comes to pass and the demand growth remains weak, oil prices could remain at levels of $60 to $70 per barrel over the next several years, leading to suppressed demand for turbines and reciprocating engines in the oil and gas industry. In such a scenario, the Global Energy and Transportation equipment market size could decline to $260 billion by 2021, which could bring down Caterpillar’s price by around 10%

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1. Drilling Productivity Report, U.S. EIA [↩]