Ask anyone running a global energy company how far the oil price will fall and you will probably get a wry smile in response. Little wonder when the market has turned on its head.
Opec’s unexpected decision in November not to cut output in the face of a US supply glut and weakening demand in China triggered a crash nobody predicted. Saudi Arabia, Opec’s de facto leader, has said it will no longer play its traditional role of swing producer.
“Whether it goes down to $20 (Dh73.46), $40, $50, $60, it is irrelevant,” said the kingdom’s oil minister Ali Al Nuaimi in December. The effect of those words has been to remove any implicit price floor. Since then, internationally traded Brent crude has hit a six-year low of $45 a barrel.
It is down 50 per cent from last summer’s peak and within touching distance of the financial crisis nadir of 2008. A return to $100-plus levels looks remote.
The repercussions of the slide are only now starting to be felt. A wave of corporate takeovers could reshape an energy industry battered by the price fall. Royal Dutch Shell’s agreed £55 billion (Dh305.72 billion) offer for UK-based BG Group, the biggest energy deal in more than a decade, may usher in further consolidation.
The winners are likely to be the world’s big consuming economies: the US, Europe and China. Households will enjoy greater purchasing power and the fall could boost overall growth in the global economy. But the regions that produce oil will be hit hard.
Countries that rely heavily on oil export revenues, those with limited foreign exchange reserves and sizeable populations — Iran, Iraq and Venezuela, for example — will struggle. Russia’s position looks increasingly precarious, with its vast energy sector also affected by western sanctions because of the conflict in Ukraine.
Thousands of workers linked to the Canadian oil sands industry, one of the highest-cost producing regions, have lost their jobs. Cities such as Calgary in Canada and Aberdeen, home to businesses operating in Britain’s North Sea, face a bleak 2015.
Market share focus
Bob Dudley, chief executive of BP, has likened the collapse in prices to the slump that crippled the industry in 1986. Then, Opec decided to switch from a policy focusing on prices to one focusing on market share, in effect a decision to allow crude prices to fall.
“This is a supply-led crisis,” Dudley says, warning that companies should be prepared for several years of lower prices.
Indeed, rising stocks of US crude, the product of America’s “shale revolution”, have almost filled tanks in the country’s storage hub in Cushing, Oklahoma.
And, even as the smaller, independent producers which have led that revolution cut sharply the number of drilling rigs used in exploration, there is no sign of a reversal in US production. It continues to glide higher.
The world’s biggest oil companies are reacting. Exploration budgets for this year are expected to be cut by 30 per cent, according to Wood Mackenzie, the energy consultancy, as the so-called super-majors axe capital spending.
Shareholder demands
Emma Wild, head of upstream oil advisory at KPMG, says shareholders are demanding the majors become “leaner and more efficient” after years of soaring costs have eroded returns on capital. Now, following the fall in prices, as much as $1 trillion of investment is at risk, says Goldman Sachs.
The oilfield services industry is bearing the brunt of a wave of cost-cutting, as rig contracts for costly deep-water exploration are pared back or abandoned. Rates for offshore rigs have tumbled 20 per cent from year-ago levels.
Except for Shell, which is pressing ahead in Alaska, drilling plans for the Arctic, the next big oil frontier, have largely been put on hold. But the scale of the cuts varies widely, with some explorers such as Tullow slashing their expenditure by up to 80 per cent to conserve cash, while Shell is keeping this year’s spending broadly steady.
Arthur Hanna, managing director for energy at Accenture, says that much of the industry had expected a market reaction to Opec’s November decision but that many executives were surprised by the rapidity of the price fall.
Share service cooperation
“That has led to a lot of activity to shore up balance-sheets for 2015. The super-majors are looking at ways shared service cooperation could be extended: financial services, pay, treasury and back-office functions.”
At the same time, billions of dollars in assets have been put up for sale amid expectations of a wave of mergers and acquisitions. Some operators are looking to reduce their exposure to higher-cost producing regions, such as the North Sea and the Gulf of Mexico.
So far, notwithstanding the BG takeover, predictions of transformative deals comparable to the takeovers of the 1990s that created today’s super-majors look overheated. Mergers on this scale are risky and — some argue — rarely deliver promised savings.
More likely is consolidation among smaller US explorers that borrowed heavily to finance their part in the shale boom and which now find themselves struggling to meet bond repayments or are at risk of breaching covenants on reserves-based bank loans.
Insulated, for now
Others remain insulated from the effects of the slide in crude, having hedged their output well into this year by selling barrels in advance at higher prices.
But those hedges will soon expire. When they do, the high levels of borrowing could have a decisive influence on what happens next. The stock of debt issued by oil and other energy companies accounts for some 15 per cent of leading US investment grade and high-yield debt indices.
Yields on the bonds issued by riskier energy groups, which move inversely to prices, have risen as oil prices fell, reflecting investors’ concerns. That pushes up companies’ refinancing costs. All this could spur consolidation.
Sarah Wiggins, a M&A partner at Linklaters, estimates there is $180 billion of “dry powder” ready to be deployed by funds including distressed equity investors. Wiggins points to $8 billion recently raised in the bond markets by ExxonMobil, the US giant, which has said it is “alert” to bolt-on acquisitions.
Other possible buyers include private equity groups such as Carlyle and Blackstone, while Russian billionaire Mikhail Fridman has launched a $10 billion fund, run by former BP chief executive Lord Browne, to hunt for acquisitions.
Constraining production
However, the fierce cost-cutting and scale of the corporate debt burden is also likely to constrain production. The reason US oil and gas output has continued to grow is that producers have focused on their most productive and profitable wells. In time, reduced investment and slower growth in output should put a floor under the market.
Standard & Poor’s forecasts a recovery for Brent to about $75 a barrel by 2017. By then, say some analysts, it will be the ‘Lower 48’ — the home of US shale — that has turned global swing producer, able to turn on and off the taps to meet demand.
Expect a volatile ride on the way, and a painful adjustment for the industry.
— Financial Times
