The Effects of High Gas Prices on the Economy According to the World Economic Outlook, continuously rising prices of petroleum prices have various effects on the world economy. The magnitude….
The impact of the recession on the value of oil and gas companies in the UK
Recession has existed as long as man and in the past it could be consolidated to one region. Nowadays, recession has become a global concern because once a region is affected; it can easily spread across the global economy. The world has faced some serious economic break downs over the past centuries some of which include; the stock market bubble in 1850, the 1929 Wall Street crash, the 1974 crash, the 1987 crash; called black Monday, the dotcom bubble of March 2000, the 9/11 attack in America and the most recent financial crisis caused by the subprime mortgages in the US.
Recession has a lot of effects on an economy as well as the industries engaged in trade in the economy. During a recession most companies lose value and this has a lot of effects on stakeholders; that is, employees and shareholders. The recent financial crisis caused firms to loss over 40% of their share value and had tremendous effects on major economies like Japan, China and the UK. The Oil and Gas Industry has also been affected by recession over the last decade. In August 2005, the price of oil was $60 per barrel and by July 2008 it had reached $147 per barrel as result of the recession brought about by the financial crisis. However, various theories have been developed to understand what determines the true value of a company. Some of these theories include the dividend valuation model, capital asset pricing model (CAPM)
Statement of Problem
Most studies have indicated a strong link between the share prices of a company, its earnings and its beta. This research is aimed at investigating whether recession has a positive or negative effect on the value of companies in the UK with the case being the oil and gas industry. While future earnings and share betas are increasingly becoming popular in determining share prices, current earnings are being used as a bench mark for share prices rise and fall or a better indicator for takeover. The relative importance of each of these indicators in predicting share prices or company value is still unknown, because sometimes investors use different methods at different times in calculating or estimating company value.
As a perfect guide and means of getting a good direction throughout this research, I intend to answer the following questions in this research.
– What determines the value of a company?
– How does recession affect oil and gas companies?
– Do post recession values of the company’s share price depend on the recession?
– What are the effects of recession on the global economy?
– What will be the necessary steps taken to prevent such a huge impact on the oil and gas industry in the future?
The main aim of this research is to investigate the impact of the recent recession trends on the value of oil and gas industry in theUK, its effects on the economy, as well as challenges faced by oil and gas companies to maintain their value. This research also seeks to identify if the prices quoted by oil and gas companies in the stock exchange market reflect their true value. Therefore, my objectives are to:-
– Investigate the major determinants of the value of a company.
– Investigate the effects of recession on the price of a share.
– To identify whether current earnings, future earnings, and share betas are of importance to a prospective investor.
– Analyse the effects of recession on the global economy.
– Analyse the effects of recession on oil and gas companies in theUK.
– Recommend solutions based on this research and other findings to prevent such a huge impact in future.
Contribution – Significance of the Objectives and the Expected Outcome
From my previous experience in the financial sector and now undertaking a financial orientation course, this research is going to ease my understanding of the stock exchange market, how it functions and how public information affects the prices of shares in the stock exchange. This research will also help in exploring the various techniques used in company value evaluation which will aid top level management in identify the most powerful indicators and enable them shape their share prices with better accuracies. During recession the beta or risk of a share is higher hence this research will also explain how relevant the beta of a share affects its price.
Brief Literature Review
Up to this date no theory has been developed to explain the movement of share prices in the stock exchange market. This has made it very difficult for prospective shareholders not to easily predict prices for shares for buying and selling purposes. Bodie et al, (2002) argued that any information that could be used in predicting stock price must have been reflected in share price; hence only new information into the market can influence the upward and downward movement of prices of shares. Share prices are always characterised with their unpredictable nature, this is because the prices of shares usually move with respect to the information that enters the market. If the information is positive, there will be an upward movement in the prices of shares and if the information is negative, there will be a downward movement in the prices of shares. This negative information is common during recession which will be the primary focus of this study. The idea that share prices already reflect all relevant information leads us to the efficient market hypothesis.
The Efficient Market Hypothesis
Lumby and Jones (2003) stated that a stock market is said to be efficient if the market price of a company’s shares rapidly and correctly reflects all relevant information as it becomes available. In this regard, if all information turns out to be entirely reliable and complete, share prices could be relied upon to correctly reflect the true economic worth of the shares. In such a market overvalued or undervalued shares would not exist. To say share prices reflect the true economic worth of a company is an overstatement because share prices are a function of future expectations which deals with uncertainty; hence share prices reflect all relevant available information. The efficiency of the stock market in pricing securities is one of the fundamental questions researchers often ask.
The objective of an investor dealing with stock market is to identify mispriced shares. Purchase undervalued shares before the price rises and sell overvalued securities before the price falls. There are three basic analysis investors use to identify mispriced securities; Technical analysis, fundamental analysis and insider information.
Technical analysis: Analyst study share price movements with the intention of discovering a pattern in movements. Once this pattern is identified for a particular company and if they see one of these patterns starting to develop, they believe they are then able to predict the shares future course of movements and so give either buy or sell investments advice.
The fundamental analyst: A variety of information is a analysed with the use of share valuation models to determine the value of a share. Comparing between the actual worth of the share with the market price is the objective here. If the worth is more than the market price of the share, then the share is undervalued and hence a buy advice and conversely a sell advice if the share is overvalued.
Insider information: All investors are looking for information insight and connections which they believe are not yet fully reflected in the market price.
Although this theory recognizes the importance of information in shaping share prices, it fails to indicate which among these indicators have a powerful influence over share prices.
Capital Asset Pricing Model and share betas
According to CAPM, the price of a share is related to the risk of holding the asset. At a relatively high risk, investors will be expecting higher returns and as such will bid dawn the share price. This is based on the assumptions that the investor is holding a well diversified portfolio and as such the unsystematic risk have all been diversified .Therefore, the return expected is compensation for the market risk, this means that, the expected return from an investment in share is equal to risk-free return plus risk premium ( Risk premium being the market price of systematic risk).
Formulated by Sharp in 1964, he argued that creating portfolio reduces company’s risk. He divided the risk into two categories namely the systematic or market risk or the unsystematic or diversifiable risk
Unsystematic risk: This risk is associated with specific factors affecting the company such as the quality of management, advertisement, research and development. According to Sharp, the systematic risk decrease as the number of investments in a portfolio increases. A rational investor should hold an efficient portfolio whereby all the unsystematic risk have been diversified away.
The systematic risk: This is called the market risk. It can be defined as the extent to which a company’s cash flow is affected by general economic factors such as inflation, interest rate, exchange rates. When there is a recession there is going to be a general fall in the share prices of all the companies. The rate at which company’s share price is affected depends on the risk associated with that particular company. This risk factor is called betas
Share Betas is the relationship between the systematic risk of company and the overall risk of stock market (market risk). It therefore measures the degree of responsiveness of the expected return of the share relative to the expected return of the market. For example if expected return of the market falls and rises, that of the company will fall and rise in proportion of its beta. It therefore measures the degree of variability of company’s return in relation to the expected market return.
Although this model has been criticized because of numerous unrealistic assumptions that question its predictive powers, the model can be credited for providing financial managers with a suitable project discount rate. The model concludes by saying the greater the share beta the higher the risk associated with that asset and hence investors are expecting a higher return from the share. The result is the share price will fall or better still the higher the beta the higher the discount rate and hence share price falls.
The weaknesses of CAPM let to the introduction of the Three Facto Model by Fama and French and in 1976 Stephen Ross developed the Arbitrage Pricing Theory which completely transformed the single Facto CAPM to a multi Facto Beta Model.
The Dividend Valuation Model
According to the model share prices are only determine by expected future level of dividends and the systematic risk of future dividend flows. It can be expressed as . Where, PE is price of share, D is dividend payout, and is cost of equity. The model assumes that future expected dividend flow will remain at a constant level for all future time period ( a level in perpetuity). Although some companies have been observed to have an approximated constant dividend per share over a longtime, in practice most company’s dividend per share are subject to changes over time. This has let to a more realistic version of the model which explains the growth of dividends at a constant rate. It can be expressed as . Where, PE is share price, Ke is cost of equity and g is growth rate.this model has been criticized for not providing information about share price when companies retain all or a greater proportion of earnings.
Recession and its effect on the UK Oil and Gas Industry
A recession is characterised with falling property prices, rising cost and personal debt and those mostly affected by it will those with low incomes. Standards of living will also fall as a result of recession and low income families will have no other option other than reducing the amount spent on basic goods and fundamentals. Estimates show that September’s 16 year high in the rate of inflation will add ?3 billion to the UK’s welfare bill. Those who will be greatly affected will include the elderly and the disabled who live on a poor diet and inadequately heated homes (Research Summary, 2008)
At the level of the stock market, investments that demand on a buoyant stock market will become increasingly devalued, a trend that may be exuberated by rising inflation. Those at risk here will include those that rely on work place pensions to sustain them through retirement and endowment policy holders who may find themselves unable to cover the value of the loan at the end of the mortgage term. Recession also comes with a lot of social ills such as more crime, violence, and anti-social behavior.
At the educational sector, recession has neither been friendly. It has affected the willingness and ability of some students to study, for instance, in order to bail the economy out of the recent recession, the government has decided to increase the school fees of students by almost triple the previous amount causing more difficulties for parents to send children to school. However, some people think that recession comes with a blessing as people drink less, smoke less, eat healthier food, and spend less on extravagant spending. Recession also speeds up the business evolution forcing companies to reduce costs and adapt new processes.
At the level of mortgages, people tend to lose their homes and livelihoods, for instance, in 2008, mortgage repossessions rose by 50% giving an average 305 people declared bankrupt every day. Krogdahl (2010), states that the recession has called for a reduction in cost, and team size of the company while their property portfolio works harder, however they are faced with the dilemma of whether their portfolio will split when their organization begins to grow.
CIPD (2009) stated that this has been the worst recession affected by UK since the Second World War. They say that the manufacturing sector has been the sector which has and is suffering most from the recession. With respect to full time and part time workers, full time workers have been more seriously affected and they experienced a downturn of -3% during the first year of recession. There has been a generally perception that as a result of the recession more women lost their jobs than men, but this ideology was dismissed by the office of national statistics which proved that lost more jobs. Between 2008 and March 2009, men unemployment rate rose from 2.4% to 8.1% while for women it rose from 1.4% to 6.4%. According to Phillips (2009), young people between the ages of 18 and 24 suffered most from the recession when it came to layoffs while old staffs above the age of 40 years were least affected.
According to Daniel (2008), most firms experience decline in profitability during recession because of the tendency of price wars which will lead to low sales which consequently lead to low revenues. Firms producing luxurious goods with price elasticity of demand >1 will experience the biggest fall in demand while firms producing basic necessities will become insulated from the effects of recession.
The IMF predicted Britain falling into the recession in 2009 as its growth rate forecast fell from 1.7% to-0.1%. David Blanch flower, a monetary policy committee member in the Bank of England predicted that over 2 million people will likely be unemployed by the end of 2008. ITV announced 1000 job cuts, HSBC 1100, UBS 1000 and GSK 400. Mortgage lending fell by 95% as a result of lack of bank financing which made it difficult for first time buyers to step into the property ladder. Pension expert Hargreaves Lansdown estimated that the system has lost ?250 million and is presently worth ?1000 million (Hopkins, 2008).
The present going green scheme has increased most energy companies expenditure cost as extra care has to be taken so as to protect the environment. In the recent recession in theUKoil demand briefly drooped by nearly 3mbpd (million barrels per day) about half of what occurred at the beginning of the financial crisis in 2008. Redundancy and forced salary cuts have also been common side effects of the current recession (Wireline News, 2011).
According to Webb (2010), in order to effectively overcome the recession, the industry needs to work collaboratively both across the sector and with Government at national, regional and local level to develop new technologies, improve working practices and efficiencies and drive down costs. This will help to enhance the UK supply chain’s comparative advantage in the global market place and ensure that the industry’s critical suppliers retain a presence here.
According to Roberts (2010), all sectors of the economy virtually depend on oil such as transport, retail, agriculture, power generation and heating. The present recession has depressed demand in a temporary or sustained way as was the case in 2008. It has rendered new oil field development more difficult especially when the main reason for development is to maintain low prices. The collapse of the oil prices and uncertainty of the depth and length of recession has forced analysts to look the cost of existing and incremental oil production and the impact of price and recession on future oil demand growth.
The research method is very relevant because the results of a research matters on the methodology used. There are two major research methods which explain how research is carried out; these are the positivism and interpretive methods (Colley and Hussey, 2009).Quantitative methods of analysis will involve working with some available data and the end result will be some kind of conclusion derived from working with the data. The ground rule here is that the researcher is independent and does not affect the subject of research (Remeniyi et al, 1998).
In the research, we are trying to establish a relationship between recession and the value of a company (share price). Therefore, accounting variables such as earnings per share (EPS), dividends per share (DPS), and current earnings will be used. This research shall use data from over 30 oil and gas companies listed in theLondonstock exchange market from 2000 to 2010. The main focus will be to see if there has been any change in the as a result of the recession in the prices of shares of these companies as well as their betas and if the prices reflect their true value. This time scale covers before and during the recession.
This research shall be based on secondary data. This is data that has already been documented for another purpose (Saunders, et al 2007). There are three types of secondary data; these are survey, documentary and data from other sources which can not be categorized. The data that I intend to use in this research will include share prices of oil and gas companies in the UKand this data will be obtained from the published financial statements and statistical information of the London stock exchange and from the internet through reliable search engines. Academic publications and articles will be of extreme importance especially from high profile financial writers and consultants. A more extensive literature review will aid in acquiring secondary data from popular writers. I intend to use primary data such as interviews with managers, stock brokers and analysts of some of the oil and gas companies so as to answer the research questions and give the research more credibility and reliability. Interviews shall be structured and shall be done verbally.
Method of Analysis and Findings
In this research both quantitative and qualitative methods of analysis will be used to analyze the collected data. Quantitative method will involve the use of statistical tools such as correlation analysis, statistical tables, charts and graphs established relationships. Meanwhile the qualitative method will be consent with comparing the strength of the relationship that exist between current earnings, future earnings, and share beta with actual share prices of oil and gas companies with respect to stable economic periods and periods witnessing recession. This research will also analyse the changes of the interest rates of some of the oil and gas companies in the UK over a ten year period.
Form of presentation
The work will be presented in both hard and soft copies. The hard copy will be presented in A4 paper format style. Data collected will be presented with the use of tables and graphs.
Timetable of Activities (Gantt chart).
Weeks from April to August