Guest article from Deloitte
To the delight of motorists everywhere, the price of oil suddenly halved in the second half of 2014, dropping from over $100 to less than $50 a barrel. It’s safe to say no one saw the fall coming: most banks and industry players had been using $70 to $80 a barrel as a severe downside case, so the scale and speed of the fall took the entire market by surprise.
Many observers initially assumed the fall in the price of oil was a temporary blip. The world consumes a staggering 94 million barrels of oil every day and the level of consumption continues to rise. New oil and gas discoveries continue to be made, but they typically occur in exotic parts of the world that are expensive to develop because they are technically difficult (miles offshore in deepwater locations), politically challenging (e.g. Kurdistan) or controversial because of the environmental impact (e.g. virgin territory in the Arctic). All of these factors suggest that the price of oil should be steadily rising. So how could the price of a commodity we all rely on collapse so far, so fast?
The story starts with the shale revolution in the United States. New technology ('fracking'), enhanced productivity and a high price environment supported a near-doubling in US oil production between 2008 and 2015, from 5 million b/d to nearly 10 million b/d. At these levels, the US came to produce as much oil as Saudi Arabia, which for decades had been the world’s biggest producer and (by its dominance of OPEC) also acted as the world’s swing producer, controlling the global oil price by cutting or increasing its production by up to 2 million b/d.
So when the oil price started to fall in mid-2014 as a result of concerns that the hitherto blistering growth of the Chinese economy was beginning to tail off, everyone expected the Saudis to cut production to balance the market. But they didn’t. Then the price fell well below $95/b, the price at which Saudi Arabia balances its fiscal budget. But they still didn’t cut production.
Gradually it became apparent that the Saudis were no longer prepared to act as the world’s swing producer; they were more worried about losing long-term market share and were prepared to see the price fall sufficiently to squeeze out the marginal producers at the most expensive end of the global cost curve.
Who was hit hardest?
At a sovereign level, many members of OPEC had become hugely reliant on oil revenues to balance their budgets: Venezuela, Russia, Nigeria and Algeria all require oil above $100/b to balance their fiscal position and were particularly badly affected. From a corporate perspective, companies producing in regions with the highest lifting costs saw their revenues tumble and their future prospects threatened. Pain was quickly felt among those with high exposure to the UK Continental Shelf in the North Sea, as well as Canada and offshore Brazil.
In response, the major international oil companies – the big spenders who feed a huge supply chain of seismic explorers, rig and vessel owners, equipment manufacturers and service companies – announced deep cuts in capital expenditure. Suppliers saw big greenfield projects postponed or cancelled, and contracts renegotiated at dramatically lower rates.
Current restructuring activity
Many upstream companies were well hedged through 2015, meaning that the full impact of the price fall has only recently started to bite for many. This has bought management teams enough time to instigate prudent self-help measures: we have seen extensive headcount reductions, working capital optimisation, overhead discipline, reduction in non-essential capex and non-core disposals made to raise cash. Nevertheless, recent analysis by our research group suggests that around a third of all exploration and production (E&P) companies worldwide are at substantive risk of restructuring – some 175 companies owing $150 billion of debt.
At the time of writing, we are seeing a flurry of bankruptcy filings in the US, where much of the recent expansion of onshore production has been funded using debt raised in the high-yield market. In Europe, the picture is more benign, possibly reflecting the fact that the market obtains a greater proportion of its capital from relationship banks who so far appear to be taking the long view and have proved more willing than expected to amend and extend their facilities in return for margin increases and consent fees.
Elsewhere in the supply chain, the picture is more challenged. There is a medium-term excess of supply over demand in the rig and offshore supply markets, driving down utilisation and day rates for floaters, jackups and seismic vessels. Some of these assets can only find work below their operational cash break-even levels. While this is clearly unsustainable, recovery may not materialise for many of these companies until 2018 or beyond, so constructing an investment case for new equity or refinancing debt is exceptionally challenging. For services companies, contract backlog has fallen in line with reduced activity levels, and pricing also remains under intense pressure as the majors implement their cost cutting programmes.
Prospects for the future?
The forward curve currently peaks at just over $60, even well out into the mid-2020s. Another five to seven years at $60/b would be likely to create a future supply shock as the lag effect of cancelled projects begins to crystallise. Unless one believes the industry has fallen asleep at the wheel, this seems unlikely. It is also worth pointing out that the forward curve is famously unreliable as a guide to the future. A credible base case scenario is to see the oil price gradually return to levels where supply can meet demand, with occasional bouts of volatility driven by short term market noise.
From an investors’ perspective, timing the cycle is challenging, but some of the most sophisticated investors are signalling that the bottom of the market is near. The US hedge fund Elliott has partnered with Kristian Siem to set up an investment platform to buy offshore vessels, while Blackstone and managers from Pride International have a similar partnership focusing on drillers and services. In the E&P space, we have seen investors get sufficiently comfortable with development and operational risk to buy producing assets from distressed owners and use forward hedging to lock in the upside, thereby eliminating commodity price risk. However, the outlook remains weak: there has been a recent surge in price given fires in Canada and issues in Nigeria and Venezuela, but it is still uncertain whether OPEC will reach agreement (and then adhere to) a production ceiling, and stabilisation of the oil price in the upper $50s is likely to support further US production. Motorists can probably plan on a cheap tank or two of fuel for a good while yet.