Oil Price Plunge Is So 1986…

Halley's Comet was making its second appearance in a century. France and the UK unveiled plans to dig what would become the Chunnel. IBM introduced the first laptop computer.

That's how far back we have to go to find a nearly precise parallel for the current drop in oil prices, says Martijn Rats, head of Morgan Stanley’s European Energy equity research team. From November of 1985 to July of 1986, oil fell from around $30 a barrel to $10. Compare that with the current dive from highs above $120 last June to around $45 a barrel as of mid-March. (See below.) The similarity is uncanny.

Not so coincidentally, many oil companies are dusting off their playbooks from that bygone era. If investors, consumers and companies want to figure out possible outcomes for the oil industry, they need to get reacquainted with the mid-1980s.

Toward the end of 1985, oil prices had been stable at then historically high levels of $30 a barrel for nearly three years. The result was weaker demand, but growing output among non-OPEC producers. When OPEC opted for market share over production cuts to support prices, the proverbial bottom fell out.

These days, we're chasing rather than waiting for comets. London to Paris takes little more than two hours on the Eurostar. Computers sit on our wrists, not our laps.

Yet the dynamics of oil are not very different. Like most commodities, oil is more susceptible now to the vagaries of financial markets, but supply and demand exert their inexorable influence. Once again, high oil prices fueled surging output from non-OPEC sources, i.e., US shale oil producers. Demand fell amid weaker global economic growth, particularly in China. Once again, OPEC has decided that it can afford short-term pain from low oil prices to starve out higher-cost competition, particularly in North America.

Past performance is no guarantee of future results, but it can serve as a guide. In 1986, the oil majors responded by delaying projects, cutting costs, but maintaining dividend yields, says Mr. Rats. Meanwhile, improved refining profits offset lost revenues from crude.

At the end of 1986, despite the drop in crude oil prices, free cash flow, a key barometer of corporate financial health and strength, remained unchanged for the majors, all of which maintained or even increased their dividend yields. When oil prices finally bottomed and then rebounded, shares of oil companies outperformed.

Today, the major oil companies are calling the same plays. Exploration and drilling projects have been shelved. Cost-cutting is gutting recent boomtowns in shale oil country, USA. But dividend yields remain solid or have even risen. “As in the past, companies are defending these dividends strongly, and we expect they will continue to do so for the foreseeable future,” says Mr. Rats. The oil majors are also tapping debt markets, giving them plenty of liquidity to wait out the storm and be ready if merger and acquisition opportunities arise.

In many respects, the current retrenchment shows the strengths of an industry built on boom and bust cycles. Whether it's 1986, 1998, 2008, or 2015, oil companies have to be prepared. Even in the oil services industry, companies that provide rigs, drilling gear, crews, ships, and other hardware—hard-hit in 1986—seem to be holding their own so far.

In the meantime, consumers can expect more respite at the pump. The drop in oil prices is acting like a global tax cut, and its biggest beneficiaries tend to be households, small businesses, and emerging market economies that bear the biggest burden of high energy costs. Economists hope that extra bit of cash may spur consumer spending just enough to prime economic growth.

For more Morgan Stanley Research on the oil industry's reaction to the recent decline in oil prices, ask your Morgan Stanley representative or a Financial Advisor for the report, “Back to the Future: Lessons from the 1986 Oil Price Collapse,” and more continuing coverage.