Ripple effect of tumbling oil prices

March 2015  |  COVER STORY  |  ECONOMIC CONDITIONS

Financier Worldwide Magazine

The oil market has long been a volatile one. Since the turn of the century, the daily price of a barrel has been, on average, 18 percent higher or lower than it was six months previously. Nevertheless, 2014 was an extraordinary year for the industry, as prices fell by 40 percent between July and December.

The price of a barrel of Brent crude oil, which was over $100 in summer 2014, was closer to $50 by year’s end. Many commentators predict that the price of a barrel will continue to fall through 2015, with some believing that $20 a barrel may become the norm. Such a price point would be of great concern for oil producers, as well as representing a startling turnaround from recent years where barrels have consistently sold for well over $100.

Yet the price drop has benefited Western consumers, serving as something of a welcome tax break. While this is obviously negative for the oil industry, in other ways economists are quite hopeful. Rather than pocketing the money they save at the petrol pump, consumers may spend it elsewhere and boost economic growth. In mid-January, the EY ITEM Club predicted that UK GDP would grow by 2.9 percent in 2015, up from its previous prediction of 0.5 percent in October 2014. Similar expectations for GDP growth have been made in other oil importing countries in recent months.

However, the oil price drop has likely been a net negative for the wider global economy, ravaging debt and equity values. In the UK alone, the number of firms filing for insolvency in the oil and gas sector trebled last year. Geoffrey Picton-Turbervill, a partner at Ashurst LLP, 2014 cited increasing concern and uncertainty in the second half of 2014. “After some years of stability, in the period since prices started to fall last summer, there has been increasing concern at the speed of the fall in prices and no knowing how much further they would fall,” he says. “The uncertainty has created significant difficulties for oil companies, both in terms of financing commitments and major projects which need a strong oil price to be commercially viable. The fall has had the effect of putting a hold on a number of transactions while companies wait to see how and when the volatility will cease and things will stabilise.” He adds that the sharp drop may also a problem for nations such as Nigeria and Venezuela, which are oil economies but lack significant foreign currency reserves.

Much of the damage caused by tumbling oil prices is likely to be seen outside of the West. In particular, it could easily magnify Russia’s economic travails. The Russian economy could lose as much as $100bn in oil revenues – or almost 5 percent of its total GDP – over the coming years. For Kuwait, the situation may be even more damaging, with a fifth of the country’s GDP at risk, though Kuwait does have significant foreign currency reserves and foreign investments which may insulate it from the worst of the damage.

The future of the industry and its producers appears to be at a crossroads. 2015 demand is likely to be lower than predicted, the Organisation of the Petroleum Exporting Countries (OPEC) is seemingly content to watch prices continue to fall, and US oil producers are hedging against the price drop. The considerable challenges and pressures ahead are almost completely at odds with the state of the industry at the start of 2014. Following a successful 2013, the year began with a degree of cautious optimism, as the prospects for the global economy brightened. For an industry now verging on crisis, where did it all go wrong?

One argument is that current problems stem from supply and demand. To a certain extent, the oil industry is reaping what it has sown. With oil prices at historically high levels for a number of years, the market began to adapt and turn to newer, more sustainable forms of energy. Although lower fossil fuel prices usually have a negative impact on renewable energy resources, today that impact is less significant. “On the demand side, a prolonged period of high prices has encouraged consumers and businesses to become more energy efficient or to switch to other sources of energy,” explains Andrew Sentance, a senior economic adviser at PwC. “This weakness in demand may also be reinforced by slower growth in China. On the supply side, US production has geared up strongly on the back of shale oil, and OPEC producers have not been prepared to reduce their supply to the market to compensate. Although the price decline has been huge, commodity markets like oil can be very sensitive to small fluctuations in demand and supply.”

Calls have been made for governments around the world to use the drop in oil prices as an opportunity to revise their renewable energy policies. The World Bank and the International Monetary Fund have both encouraged emerging markets in particular to remove subsidies for energy companies.

Shale gas

US shale production has been a key narrative of recent years. The explosion of shale production caused a revolution in the US energy landscape, which has major repercussions across the rest of the market. According to recent estimates, the US now produces around 9 million barrels of oil equivalent per day, roughly the same as key OPEC member Saudi Arabia. US shale reserves are so sizeable that the country is considering whether to export some of its surplus for the first time. Clearly, the impact of the US shale revolution is being felt worldwide, threatening the power dynamic within the wider oil and gas sector. “The dramatic fall in the oil price is challenging the industry, which is facing uncertainty and volatility,” says Penelope Warne, a senior partner and Head of Energy Oil & Gas at CMS Cameron McKenna. “The industry faced a similar dilemma in the early 1990s, but at that time OPEC’s role was significantly different. Today the US oil shale boom means that the oil price is now at the mercy of market forces, not OPEC.”

OPEC’s role in the oil industry’s future will be pivotal. The organisation has been reluctant to reduce oil production – apparently as it attempts to wrest back control of the industry. “The strategy will not change,” said Suhail bin Mohammed al-Mazrouei, Energy Minister of the United Arab Emirates, in January. “We are telling the market and other producers that they need to be rational.” He also noted that it could be years before oil prices stabilise. OPEC’s continued production schedule has already begun to put pressure on fracking projects in the US, where the cost of drilling for shale gas exceeded the cost of oil in January. With fracking wells beginning to close down production in several locations, the country’s much vaunted shale revolution may already be under threat.  The battle between OPEC and the shale gas industry is set to rage on.

Global economics

The declining oil price is likely to play a significant role in shaping the global economy in 2015. A number of countries will begin to feel the squeeze. “Some oil producing economies will struggle, particularly those that rely on oil to generate a large amount of government revenue, such as Russia,” says Mr Sentance. “There may be a similar negative impact on Venezuela and some of the Middle Eastern producers. But the impact for the world economy as a whole should be positive. The larger economies in the world, like the US, the euro area, China and Japan are all net oil importers. The largest oil importing economies are about nine times as important to the world economy as the large oil exporters. However, it may take 6-12 months before consumers and businesses in oil-consuming countries begin to adjust their spending. So, we should see a stronger positive impact on growth in the second half of this year than in the first half – that is, assuming that the decline in the oil price to $50-60 per barrel is sustained,” he adds.

Saudi Arabia lost around 50 percent of its national revenues in December, when the price of oil dipped to around $60 per barrel. Russia’s economy endured a rough 2014 and this year is shaping up to be just as damaging. Already feeling the bite of US and European sanctions against its actions in Ukraine, the rapid decline in oil prices could have a disastrous effect. The IMF has suggested that Russia’s GDP could contract by 3 percent in 2015. Ratings agency Fitch predicts it will shrink by 4 percent, and has reduced its rating of Russia’s sovereign debt to junk.

Insolvencies and pressures

Of course, economic turmoil is unlikely to be limited just to oil producing countries. In the industry itself, oil companies and their suppliers will be adversely affected by changing market forces. In the UK, 18 firms in the oil and gas industry filed for insolvency in 2014, compared to only six in 2013. While the oil industry is resilient, and has a remarkable ability to adapt to changing circumstances, further insolvencies are likely, and significant restructurings practically unavoidable. “Smaller and medium sized companies in particular may have difficulty in meeting debt service commitments, or may find themselves in breach of financial covenants, and so will need to enter discussions with lenders with a view to restructuring their arrangements,” says Mr Picton-Turbervill. “It is also inevitable that projects will be cancelled or postponed; many projects – particularly in challenging geographies – require oil to be in the region of $70-80 to be viable.” Goldman Sachs is reported to have said that about $1 trillion worth of planned oil projects are now at risk of cancellation.

Energy consultancy Wood Mackenzie reports that there are currently around 30 burgeoning oilfield developments in Europe awaiting approval. These developments, collectively worth more than £55bn, are said to be at risk if oil prices do not improve in the near future. Similar projects worldwide are also under threat.

Despite the pessimism permeating the industry, it is important for firms to remain positive. The oil and gas industry has endured periods of serious difficultly before and overcome the inherent challenges. “Over the next 12 months, there is a real likelihood that the oil and gas industry across the North Sea and UK as a whole will become increasingly cash-constrained as a result of high production costs, low oil prices and what has been a mixed reaction to implementing much needed cost reduction programs,” says Alison Baker, head of UK oil and gas at PwC. “Nevertheless, it’s important to remember that this industry has proved to be very resilient in the past, and if it gets its working capital and cost reduction strategies right, there is every chance it can ride out the storm.”

M&A activity

The ripple effect of the oil price crash will carry into M&A activity, as firms begin to explore asset sales. Smaller oil and gas explorers that lack strong balance sheets will become vulnerable acquisition targets for entities seeking growth. “For some companies, in particular those that have cash, the current situation may offer opportunities. If prices stabilise at relatively low levels, there may be opportunities for acquisitions of assets at attractive prices, and some smaller companies may also become attractive takeover targets. We may also see funds which invest in distressed companies entering the market for the same reason,” notes Mr Picton-Turbervill. Some analysts have even suggested that an industry giant such as BP could become an M&A target in 2015. However improbable such a deal may have seemed just a few months ago, current oil prices could have a lasting effect on the composition of the entire industry.

Conclusion

2015 will be a trying year for oil and gas companies. With prices continuing to fall and the world’s largest producers in a stand-off, the sector will be in a state of flux for the foreseeable future. That said, ambitious companies may have a chance to seize opportunities and improve their standing for years to come. For other players, there are many pitfalls ahead. If firms are to survive the current turmoil, they must learn to be flexible and adapt to external forces.

Renewable energy sources are likely to grow substantially in the coming years. Indeed, cleantech energy investment grew 16 percent to $310bn in 2014, according to Bloomberg New Energy Finance. On a wider scale, the prospects of oil producing countries including the US, Venezuela, Saudi Arabia and Russia will have serious implications on a geopolitical level, as well as an economic one.

© Financier Worldwide

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Richard Summerfield