The dramatic decrease in the price of crude oil over the last eleven months has had ramifications across the globe. With prices currently languishing between US$60 and US$65 a barrel following the decision in November 2014 by the Organisation of Petroleum Exporting Countries (OPEC) to keep its output levels unchanged (a decision re‑affirmed in June 2015), oil companies the world over have been forced to slash investment by reducing capital expenditure and exploration spending while simultaneously implementing a raft of cost cutting and efficiency measures.
This has had an immediate impact on oilfield service and supply companies who face cuts in pricing and volumes of work with resultant uncertainty as to what the future holds.
A UK perspective
The North Sea oil industry, with its ageing and depleting oil fields has been particularly hard hit. In recognition of this, Chancellor George Osborne was prompted to announce a £1.3 billion support package to the industry. While this move was broadly welcomed there have been warnings from many, including the Chief Executive of BP, that these measures may not go far enough to avoid a bloodbath for smaller drillers and exploration companies.
This warning follows a study by the International Monetary Fund suggesting that the UK’s oil and gas industry has the highest cost structure of any major region in the world - if taxes are included - and is therefore the most vulnerable to a prolonged downturn.
British companies operating in the sector must navigate a global landscape of over‑supply and the uncertainty that this crude glut may further exacerbate the downward pressure on oil prices if international sanctions on Iran (as part of a general framework relating to its nuclear programme) are lifted such that its production dramatically increases.
Risk of financial contagion
There is little sign of oil prices increasing in the short to medium term and so the prospects for many appear very difficult. The scale of the potential implications are sobering. A recent report prepared by Ernst & Young (commissioned by Oil and Gas UK with the support of the Department for Business and Skills, the Department of Energy and Climate Change and the Scottish Government) based on their examination of over 3,000 companies actively involved has shown the UK supply chain alone to be a £35 billion industry (based on 2012 figures from businesses registered with Companies House).
A QI 2015 analysis revealed that UK quoted companies issued 77 profit warnings in the first quarter of this year. The rapid fall in oil prices at the end of last year contributed to 16 of those profit warnings. This includes a record eleven warnings from within oil and gas sectors and five from elsewhere, primarily the FTSE Industrial Engineering sector.
The majority of upstream exploration and production (E&P) companies are significantly hedged at US$80 a barrel and have, to a large degree so far, been shielded from the full effects of the oil price downturn. As existing hedges run off however, new hedges will be at much lower prices or may potentially be prohibitively expensive.
There is a real risk that the adverse impact already felt by E&P companies will exacerbate and spread. The simplest way for oil production companies to cut their costs is to pay less to their suppliers. Recent press reports indicate that large companies have been calling in suppliers, demanding cuts to rates and the pressure exerted on such service companies is reflected in the job losses and a general scaling back of operations that has been a feature of news headlines. Against this backdrop, it is imperative that businesses operating in, or connected to, the oil and gas sector prepare for the inevitable distress that will be encountered across the entire spectrum. With cash flow depleted up‑stream, some oil companies will face difficulties funding operations, servicing debt, fulfilling contractual obligations and funding new projects.
Consequently, a number of oilfield service companies are facing issues around payment delays, contractual defaults and project cancellations or postponements. These companies have their own sub‑contractors so the problems get passed down the chain and extend, naturally, to the lending community now encountering covenant breaches and payment defaults and, ultimately, to equity investors who will see underlying values affected.
Recommended action and legal/commercial considerations
We recommend that an immediate review of strategically important contracts should be undertaken. Contracts should be considered in light of the businesses own financial position, the possible distress of the counterparty and the risk of delay, breach and termination. Examination will be against a potentially altered financial dynamic to that in place when the contract was first entered into. It is important that directors understand and identify both the risks and opportunities that will present themselves. We suggest that the following legal and commercial areas should be considered:
Customer and supply side resilience
The following is critical to customer and supply side resilience:
- Companies should monitor events and patterns as they occur, focusing particularly on the financial viability of their contractual counterparts (be they customers, suppliers or sub‑contractors). This will allow companies to proactively - and preferably pre‑emptively - address problems and, in some instances, improve their bargaining position.
- Being able to adapt to problems quickly, without significantly increasing operational costs and make rapid adjustments that limit the impact of disruptions.
- Maintaining relationships that allow you to work closely with supply chain partners to identify issues and avoid disruption where possible.
- Ensuring your contractual rights are as robust as possible to enable you to protect your position. Do you have retention of title or other contractual or security protections to put yourself in the strongest possible position in the event of the insolvency of the counterparty?
- Can you negotiate rights of access or information likely to give you an early warning of counterparty insolvency so as to put you ahead of other competing creditors and therefore minimise the otherwise inevitable losses. Where there is risk of delayed performance or, even worse, complete failure to perform by the counterparty, the implications need to be understood.
- Where a contractual default appears likely, planning in advance so as to manage the potential consequences of default is imperative. It is important that the potential liabilities which may flow from default events are mitigated.
- It may be that particular contracts entered into pre oil price collapse are no longer profitable and corporates are looking to extricate themselves. A full understanding of contractual rights and obligations is important to assess termination rights and, where termination rights are not available, to understand the consequences of your own breach. In order to minimise potential damages claims you first need to appreciate the rights of both parties. Once understood, it may then be possible to terminate or negotiate a more advantageous outcome. Particular attention should be paid to contract formalities (e.g. time limits and notice requirements).
- The expiry of favourable hedge arrangements, constrained cash flows and depressed asset values increase the chance of covenant breaches. The rights and likely attitude of lenders in such circumstances should be understood (as should your refinancing options in the current climate - there has been a reported contraction in reserve based lending for example). Early engagement with financial backers and other stakeholders will increase the chances of a successful resetting of covenants or other form of restructuring.
- A reduction in staffing levels has been a well‑publicised feature of the downturn already. To the extent that redundancy programmes are being considered, it is crucial that the employment laws of the jurisdiction concerned should be fully understood and complied with.
- The aim should be to minimise financial liability and legal action consuming management time and damaging further employee and public relations.
Safety, health and environmental issues
- Safety, health and the environment are vital topics for all businesses but particularly so for those operating in the oil and gas sector. On the one hand, noncompliance with regulatory requirements and failure to address potential liabilities both carry increasing financial risks for all companies. On the other, the ability to demonstrate good environmental and safety management is not only important for business reputation, but is often a key condition of obtaining both public and private contracts.
- Those companies looking to decommission off‑shore oil field facilities as a result of low, end‑of‑lifecycle margins compounded by low oil prices must understand and comply with the strict legal framework of national and international regulations which govern the decommissioning process.
- Directors of distressed companies should consider their own legal duties.
- Insolvencies in the sector are on the increase and directors of companies in a precarious financial state ought to be considering their own personal position when it comes to continued trading and the risk of antecedent transactions being entered into.
- Oil is a global industry which operates across borders. Consideration should be given to the country whose laws will apply in any given situation and which courts are likely to have jurisdiction over issues arising.
- M&A is a clear way of achieving substantial cost reductions. The proposed acquisition by Royal Dutch Shell plc of BG Group plc which has recently received US federal clearance may well represent the klaxon starting on an anticipated increase in such corporate activity. Consolidation in the sector may yet prove to be a feature of 2015.
- Equally, we expect to see more distressed sales and opportunistic public bids for companies with good underlying assets but the wrong financing structure. For those corporates able to weather the storm, opportunities to cherry pick assets and otherwise acquire good underlying businesses from insolvent companies will increasingly present themselves. Well-funded companies should take the opportunity to raise acquisition funds so as to position themselves favourably to take advantage of potentially cheap, distressed assets.
- Other possibilities may arise in the form of opportunistic pricing given the over‑supply in the upstream market as well as favourable contractual renegotiation with counterparties who find themselves in a weak bargaining position.