How Freeport-McMoRan Would Benefit From A Recovery In Oil Prices

The recent decline in oil prices has taken its toll on Freeport-McMoRan Inc. (NYSE:FCX). Though Freeport is primarily engaged in the mining of copper, the company ventured into the oil and gas business in 2013 through the acquisition route. Due to the sharp decline in oil prices, which stood roughly 60% lower in January from the levels seen in the middle of last year, there has been a sharp reduction in upstream capital expenditure by oil companies in North America. ^[1] Freeport-McMoRan has followed suit, announcing a $1.2 billion reduction in its upstream oil and gas capital expenditure for 2015. ^[2]

Crude oil prices have declined due to weak demand and an oversupply situation. Demand for oil remains weak in the midst of economic weakness in Europe and slowing Chinese growth. China, the world’s second largest importer of oil, is expected to witness a slowdown in GDP growth to 6.8% and 6.4% in 2015 and 2016 respectively, from 7.4% in 2013. ^[3] Global oil supply has been boosted by rising oil and gas production from the U.S., where hydraulic fracturing techniques have helped boost output. In addition, major oil producers of the Organization of the Petroleum Exporting Countries (OPEC) have not lowered output in response to falling prices, in order to preserve their market shares. ^[4] With a weak demand situation compounding a supply glut, oil prices have declined sharply.

Oil prices have recovered marginally from their levels in January. We expect oil prices to increase gradually over the next couple of years, as global demand recovers and capital expenditure cutbacks from producers result in the tightening of supply. However, there is a possibility of a sharper V-shaped recovery in prices, if demand grows faster in response to lower prices, or if OPEC alters its stance and reduces production in response to low prices. Such a scenario will significantly boost the prospects of Freeport’s Oil and Gas division. In this article, we will explore the impact of a V-shaped recovery in oil prices on the company.

See our complete analysis for Freeport-McMoRan

Impact of V-shaped Recovery in Oil Prices on Freeport-McMoRan

In the event of a faster than expected recovery in global economic growth, demand will recover sharply in response to low oil prices. This will provide a boost to global oil prices. However, for a V-shaped recovery in oil prices, a calibrated reduction in output by OPEC is essential in order to lessen the supply glut and result in a more favorable supply-demand equation. Given that oil and gas output in the U.S. will fall due to upstream capital expenditure cutbacks, OPEC may also reduce output in response to low oil prices. If we assume that a combination of recovering demand and a calibrated reduction in output by OPEC drives up oil prices close to $100 per barrel by 2016, there could be a significant increase in U.S. oil and gas production. Around 98% of crude oil and gas production from the U.S. has a break-even price of below $80 per barrel. ^[5] If prices exceed $80 per barrel for sustained periods of time by 2016, there could be a significant increase in U.S. oil and gas production. Such a scenario would also result in significantly higher output from Freeport’s Oil and Gas division. A sharp recovery in oil and gas prices would boost realized prices for the Oil and Gas division and the combination of higher volumes and pricing would boost the division’s margins. In addition, there is likely to be an increase in upstream oil and gas capital expenditure for Freeport, which would boost the company’s overall capital expenditure. However, whereas the absolute capital expenditure will increase due to higher capital spending by the Oil and Gas division, capital expenditure expressed as a percentage of EBITDA (as forecast in our model) will decline slightly due to the higher EBITDA generated by the company in the V-shaped recovery scenario.

If we factor in the impact of a V-shaped recovery in oil prices on the relevant drivers for the Oil and Gas division in our stock price estimate for Freeport-McMoRan, it boosts our price estimate by around 30% from $13.94 to $18.11. Thus, in the event of a sharp recovery in oil prices, an upward adjustment in valuation could potentially follow for Freeport-McMoRan.

See our complete analysis for Freeport-McMoRan in the scenario of a V-shaped recovery in oil prices

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1. WTI Crude Oil Spot Prices, Y Charts [↩]
2. Freeport-McMoRan’s Q4 2014 Earnings Presentation, Freeport-McMoRan Website [↩]
3. World Economic Outlook, IMF [↩]
4. Global Oil Glut Sends Prices Plunging, Wall Street Journal [↩]
5. Low oil prices to bite into 2015 U.S. shale growth: IEA, CNBC [↩]