26th March 2015
The past ten years have seen immense change in the petroleum industry. Oil price has risen at 12% p.a., but global production has grown at only 1% p.a. In North America however over the past five years, technology breakthroughs have driven production to grow by 9% p.a. A phenomenon initiated in 2004 when Continental Resources completed the first commercially successful “fracked” well in North Dakota in shale. In 2009, oil prices reached breakeven levels for unconventionals in the US and domestic operators were able to “surf this wave” and bring US production back up to heights not seen for 25 years. Whilst over many years we have become accustomed to Saudi Arabia acting as a swing producer for OPEC, today, oil production from US unconventionals represents around five times the flow rate that Saudi Arabia would normally use to control the market and prices.
Production growth is not just about US unconventionals, it has also come from large deep water offshore projects in Angola and Brazil and lower cost conventional production from Iraq, Kazakhstan, Colombia and Oman where national policies have encouraged the deployment of “Enhanced Oil Recovery” or EOR to maximise economic recovery.
It is not all positive news however. Some potential “Efficient Producers” have not seen production growth. Countries such as Iran, Mexico, Venezuela and Argentina have seen drops in production as they struggle to evolve from state monopolies to a more open market position. Elsewhere, natural decline has seen the big producers of the 1980s such as the North Sea and the Alaskan North Slope fall away.
So how is the current price shock already impacting the E&P industry? The answer is clearly different for different types of asset. GCA have looked at the internal rate of return and net present value creation for a number of key assets types under three different price scenarios:-
Pre-crash oil price [$90/bbl]
Post-crash modest recovery oil price [$70/bbl]
Post-crash sustained low oil price [$50/bbl]
Our analysis highlights the role that high oil price played in enabling unconventionals to develop strongly in the US with very attractive Internal Rate of Return (IRR) levels with prices at pre - crash levels. It is clear that should oil prices remain at low levels going forwards then unconventionals will be significantly stressed commercially. In key shale oil projects where breakeven costs are highest we are already seeing cut backs in drilling activity through rig laydowns. Whilst this has been severe, GCA analysis has suggested that this will likely result in a near term fall in production, but the industry is already established and should prices go back up a rapid recovery of production levels may occur similar to what happened in the last downturn in 2008/2009. It will however likely result in some forced consolidation and even business failures for those companies with high levels of exposure in this space who are slow to act.
Elsewhere in oil sands, the picture is a little different. Although oil sands have higher production costs than other plays, the projects are on very long decadal investment cycles and require very large initial capital outlays. It is therefore not simple to step investment up and down quickly as can be done in shale oil projects. Whilst low prices might defer new investment decisions, existing projects are likely to continue for as long as oil prices are close to or exceed the more modest operating costs. When the price does pick up and where the choice exists, new investment will be more likely to flow into shorter cycle unconventional plays such as shale oil before new oil sand projects.
Conventional onshore and shallow offshore projects are also challenged by lower costs of course, but in general remain attractive propositions. The current environment puts a lot of focus upon cost reduction and cost management. It may also encourage national resource holders to rethink their strategies to ensure that they can continue to attract the development capital they require to monetise their national assets in what is now a very competitive marketplace. Offshore, conventional projects developments will continue. The higher costs associated with operating offshore may bring an early close to some mature assets, and some newer projects are likely to be postponed even though it is the oil price in the long run that is important for these projects rather than the depressed price of today. In the meantime – offshore operators will work hard on cost control and new developments will be looking to use the softer market to lock in lower contract prices for offshore construction and operations work.
The higher costs associated with deep water offshore developments are such that a low future price scenario will inevitably hold back investment decisions, but interest and activity will likely sustain because such projects often provide very large absolute value creation opportunities. Furthermore, they are long term in nature and again it is the oil price in the long run that is important for these new projects rather than the price of today. Because of this, projects already under development in areas like Brazil and Angola with already resolved financial structures are unlikely to be impacted in the short term.
This is not the first price shock in the industry and it won’t be the last. Down cycles force companies to re-visit their core strategies and consider rebalancing their portfolios. This will help to ensure that petroleum assets are owned by the companies best able to monetize them. Our discussions in the marketplace suggest that asset owners will find themselves in one of the following three groups:-
These are characterised by single asset or single jurisdiction portfolios, often in high cost areas with looming decommissioning liabilities. Portfolios may be highly fragmented as a result of late entry or lack of focus. Often the assets are providing minimal cash flow, or the owner is in a non-operating position with little influence or control over operator spending. Such companies will be very sensitive to reserve write downs and impairments resulting from current market conditions. These factors coupled with over levered balance sheets can make access to new equity quite challenging.
These companies will focus immediately on cost discipline and high grading capital projects. They will move to renegotiate contractual obligations where they can and will also use relinquishment to achieve focus. They will require innovative options for financial restructuring and strengthening their balance sheet and they will be forced to assess strategic options around consolidation or merger possibilities.
Weathering the Storm
These owners have larger vessels in which to weather the storm. The will have more diversified portfolios, but will also have some capital commitments shared with partners. They will have a mature hedging strategy which will have supported the preservation of cash flows, but they are often still exposed to high cost structures. They will be susceptible to write downs and impairments on some assets, but their broader portfolios will provide options to de-lever over levered balance sheets. In summary these owners are well placed with withstand choppy seas for a short period, but may become distressed should the period of low oil price persist for any length of time.
The initial focus of these companies will be on cost discipline and high grading their capital projects. They will revisit their corporate strategy and then their portfolio to ensure it remains aligned with strategy. They will use the downturn as an opportunity to rebalance and focus on core assets so that they are ready to grow strongly as the recovery starts. Their broader portfolio offers more options for financing.
Opportunistic / Predatory
These owners have strong capital and cost discipline in all phases of the cycle. They have quality and well balanced portfolios and strong balance sheets. They have ready access to cash, reserves, equity and debt markets. They are often larger in size, although there are also some well-funded small companies in this position.
These companies see this market dislocation as an opportunity for growth. They revisit strategy on a frequent basis and execute on this to create value through, A&D activity, consolidation, portfolio rebalancing, growth and new entries.
So what is it that companies should be doing now to manage the current situation?
All groups need to revisit and reconfirm their corporate strategies. They should clarify and decide what they are really good at and how to leverage that to get to where they want to be in the long term. All companies with portfolios need to check that these are aligned with strategy and that they have the right costs structures. They must look at all alternatives and build a robust execution plan. Finally the company must ensure it has a long term perspective and ensure it can engineer the balance sheet that it requires to execute its business plan. In particular ensure that all alternative sources of financing have been investigated.
All in all the low oil prices, geopolitical uncertainty, slowing global growth and high cost structures come together very much like the Perfect Storm. It is at these times however that the well prepared and visionary companies with strong leadership will create significant advantage beyond that of their peers.
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