The Impact of Commodity Prices on the E&P Sector:  Project Costs

The Impact of Commodity Prices on the E&P Sector:  Project Costs

20th June 2016

In a series of three articles this week, GCA will present a summary of the presentations given at its recent event held at the Royal Institution, entitled: "The Impact of Lower Commodity Prices on the E&P Sector". Over 120 people attended and more wished to but were unable due to space limitations and a transport emergency in London.  This article is for all those interested parties who were unable to make it to the live event.  Do contact article authors if you wish to pursue any of these subjects further. 

The three articles in turn will consider: 

- The Impact of Lower Commodity Prices on the E&P Sector: Project Costs

- The Impact of Lower Commodity Prices on the E&P Sector: Reserves and Resources Reporting

- The Impact of Lower Commodity Prices on the E&P Sector: Reserves Write Downs and Impairments.

The Impact of Lower Commodity Prices on the E&P Sector: Project Costs

The E&P sector is in a state of depression with many business indicators showing the impact of enduring low petroleum commodity prices. As a simple measure, if we consider globally a $50/Bbl oil price reduction on global production of 94 MMBOPD, that is a massive $1.7 Trillion hole in the E&P bank account.

The full effect of lower oil prices was somewhat mitigated last year by the effective use of oil price hedging and residual strength on balance sheets, however the expiration of hedges over the last few months and draining of balance sheets has resulted in many players now exposed to the grim impact of low pricing. The constant trickle of E&P company failures continues even with the recent higher prices.

Transactional events are also showing the impact of low commodity pricing. Acquisitions and Divestments (A&D) activity is extremely low in the E&P sector as shown in Figure 1. The first quarter of 2016 showed no respite with activity being only 20% (in value terms) of the normal quarterly average although indications are that the 2nd quarter has improved.

Figure 1: Global Oil and Gas Transactional Activity

Across the industry there has been a retrenchment with virtually every E&P player having significantly slashed investments, including NOCs, IOCs and mid-caps. Reported CAPEX investment has been cut globally by circa $100 Bn/Year with many companies reporting 20-25% reductions in their planned CAPEX programmes. Smaller players having cut expenditure to the bone, are holding on with minimal tickover operations, attempting to balance costs to cashflows and survive.

The impact on the industry should also be viewed in personnel losses. Estimates for headcount loss in direct roles related to the global E&P sector hover around a figure of 300,000 since the 2014 oil price decline. Further estimates for 2016 suggest another 100,000 will be lost by December. This cull of personnel equates to approximately 10% of the estimated global workforce, such numbers may prove to be a long-term concern for the industry when recovery does occur, whereby insufficient competent resources could be available to fuel a step up in production and construction. Such skill losses in 1998 and 1993 presaged turbulent subsequent markets with a direct impact on both CAPEX and OPEX.

Forward positive news has been limited; OPEC appears to have little interest in agreeing production constraints and global oil storage volumes remain at record highs. However in the last couple of weeks, further positive news on pricing is coming from the production-consumption balance apparently moving from surplus to deficit earlier than expected mainly due to problems in producing nations such as Venezuela, Canada, Iraq and Nigeria. Current predictions of the inflection point from surplus to deficit having already been reached are good news versus prior predictions from commentators claiming any deficit would be at end-2016/early-2017.

Ultimately the industry will respond and pricing will start to climb as the production-demand deficit widens. Global GDP and hydrocarbon growth will continue to grow steadily and furthermore fields in production today will still exhibit natural decline averaging around 5%. However the vast volumes of oil inventory around the globe will take time to realign to pre-2015 levels, meaning that any upward pressure on pricing may well be buffered for a period of time as stored oil enters the market to balance the production-demand deficit. A similar buffering effect on upward oil prices is likely from North American production where significant volumes sit in basins tiered at differing breakevens. It may be some time before oil prices see, or even view from a distance, a $100/Bbl price tag again.

CAPEX will drive decisions when Commodity Prices are Flat

The forward economics of the industry will be controlled by two primary issues in the short to mid-term, these being a likely 45 to 60 $/BBl oil price band as well as forward trends in CAPEX. The issue of forward trends in CAPEX (and to a lesser degree OPEX) is therefore important to project decisions. Project cashflows/NPVs tend to show significant sensitivity to CAPEX (in a stable commodity price environment), whereas sensitivity to OPEX tends to have a lesser impact on investments but a major impact on the commerciality of mature assets.

It is an often-raised question as to how the unit CAPEX costs of the industry follow commodity prices and also how far can unit CAPEX indices fall (or rise) in relation to the oil price. GCA has represented the idealized CAPEX relationship to commodity price in Figure 2.

Figure 2: Simplified Industry Cycle – Oil Price and CAPEX Index

In terms of CAPEX, GCA’s extensive experience of hundreds of actual project per year has allowed us to assess the CAPEX markets in detailed granularity so we can see how costs have trended, how CAPEX varies with other market parameters and if there is a relationship with commodity prices.

To analyze CAPEX indexes in relation to commodity prices, GCA distilled down the CAPEX market into the 4 main contributory business sectors and then we looked at the margins that are typically achieved by the companies inhabiting those business sectors.  Those 4 business sectors are identified below, and in addition, GCA has shown the typical 2015 operating margins achieved by such companies:

     - Fixed Asset based services such as drilling rigs and installation vessels/spreads: 35-40% margins
     - Oilfield Service Providers: 15-20%
     - Equipment Suppliers: 10-15%
     - Manpower – EPC, FEED and project management providers: 8-10%

If we consider the entire global CAPEX market, and reflect the global revenues associated with the 4 business sectors above and then estimate the extreme minima where each business sector can operate, overall project CAPEX unit rates could not fall beyond an additional 20% from end-2015 position (circa 40-50% from peak-2014). That point has already mostly been reached in North America and other locations are not far behind.  Some caution is due though since 2015 margins contain contractual “lag” from contracts/rates signed in different rate environments from prior years. In addition, many business sectors can operate sub-economically for short periods, and do so, given it is more efficient to keep yards and equipment busy at sub-economic rates than to decommission and scrap. Hence the calculation should be viewed as an approximate guide.

On the high side, CAPEX unit rates could obviously climb again as commodity prices upturn. There is no simple method to calculate the maxima for CAPEX growth, however from empirical information we typically see an uplift of 40% in unit CAPEX (above long-term average rates) before market forces tend to respond, through either CAPEX impacting project NPVs negatively, or from new capacity from existing suppliers or new entrants, creating self-regulation.

It should also be noted that unit CAPEX appears to trend upwards with a significant lag after commodity prices increase, whilst unit CAPEX tends to fall rapidly after a commensurate commodity price decline. The reason we find for this behavior is that as commodity prices increase, there is an inherent expandable capacity in the market which needs to be exhausted before unit CAPEX rates increase. The impact of long-term EPC or charter contracts also limits market movement. In a declining market there is a need for companies to look after market share (to fill future order books and keep equipment and people busy) and therefore companies tend to reflect declining forecasts and not immediate market conditions in their bid pricing.

So in summary, whilst commodity prices are likely to sit in a narrow band in the short-term, the impact of CAPEX becomes primary to project viability and asset values. Whilst CAPEX is impacted by commodity price trends, the relationship is complex, and reductions in achievable project CAPEX are already near to the lowest possible levels.

Authors

The Impact of Commodity Prices on the E&P Sector:  Project Costs

Drew Powell

Global Operations Director - drew.powell@gaffney-cline.com

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