By PWC

Boom to bust – the familiar cycle for the commodity business of oil and gas – is once again rearing its head. Oil prices have declined over 50% within the last several months. Natural gas prices are following suit, with excess supply in the market. How low will prices go? How long will the price decline last? These are the burning questions of the day. But industry experts know that to provide products for the future, the planning and investment must continue today. Throughout the value chain, oil and gas projects take years to develop, and price fluctuations are all a part of the process.

The energy industry requires long lead-time for new projects, and even though the current global economy is struggling, the world’s population continues to grow. With this growth, energy demand will increase. Weighing the risk versus benefit of new projects, new products and how much capital to invest, oil and gas companies also have to consider regulatory, safety and environmental concerns. Balancing the need to supply the world with hydrocarbons, companies are also looking at investments in alternative energy sources, including unconventional sources, biofuels, renewable energy sources, and ways to improve energy efficiency.

Industry Impact of Oil Prices

• The toll of the oil price is already visible and will continue to grow
• Discretionary spending is being cut, rigs stacked, utilization is falling, and there are signs of distress- particularly in small E&P companies.
• Financial warning signs from companies with exposure – dividend suspension/profit warnings.
• Covenant breaches and early stages of restructuring.
• Bonds trading down in secondary markets.
• Reserve Based lending market contracting.
• Operators are pulling traditional levers in response to low oil price: headcount reduction, reduced use of contractors and reduced capex levels; renegotiating OFS rates; deferring investments and in some cases abandoning major project investments.
• Limited consolidation in the sector with valuations being challenged but a major wave of M&A imminent.
• Sector will need to be wary of losing core capabilities with downturn.
• Significant decrease in capex commitments announced by multiple players.
• Middle Eastern governments will have their fiscal break even price challenged with subsequent implications for geopolitical instability.
• OFS sector focusing mainly on headcount reduction.

In oil fields’ services (OFS), a spread from front-end explorer-developers gradually trickling down more widely via major projects.

• Opex and discretionary capex will be cut first; development projects could be next at risk.
• Some protection right now from contracted activity.
• In time other capex will be trimmed, project targets reset and larger companies affected.
• Merger and Acquisition (M&A) activity may be used to cut costs, both in E&P and in OFS.

In downstream, there are positive arguments being made for refining –positive impact on funding could be seen, but not a fundamental impact.

There has been limited consolidation to date, but this may change.

• Low oil prices are impacting financially distressed companies, particularly those with high gearing.
• Volatility in crude prices is expected to curb deal making for a period, as it is becoming more challenging for buyers and sellers to reach agreement on price.
• However, if prices remain low, pressure on oil companies’ revenues will grow, forcing many to divest non core assets or accept bids, creating opportunities for financially stronger groups.
• Already a few major deals have been announced (see table) which are likely to be a precursor to significant consolidation in the market.
• Major M&A Deals in Oil & Gas Selected Nov. 2014 – Jan. 2015.

Comments

• Government budgets have grown due to public sector salaries and inflated levels of spending on welfare, subsidies and infrastructure investment in recent years.
• Many countries have break even price well above current price.
• Several states will have access to substantial sovereign wealth funds to mitigate any shortfalls.
• However, many governments will have to review spending and perhaps identify cutbacks.
• Given the dominant role of state in these economies, this could lead to a slowdown in some countries and fan political unrest.
• Citi recently predicted real expenditure in KSA would drop to US$241bn this year, down 18% on 2014.

Effects of low oil prices will spread

First Impact:

Low-margin production or large capex commitments

• Early stage or exploration spending can be readily cut/deferred; high production gives shelter against low prices.
• Late-life assets with high fixed costs could become cash-negative, recognizing the associated decommissioning risk.
• Committed projects can be hard to stop even if development is no longer justified: covenants may be breached.
• Stable companies will cut their sanction/planning oil prices from c.$100 to $75 or less.
• Companies will seek to renegotiate contracts, reduce rates and/or exit through M&A or decommissioning.
• Impact on OFS companies, rig owners, vessel owners & supply firms, from cuts in pricing and volume

Mid Term Impact:

Projects yet to be sanctioned, mainstream producing fields

• Major economic developments at $120/bbl may no longer be viable; if possible spending is to be cut/deferred.
• Impact on rig owners with vessels coming off contract, pipelay, project management, shipyards etc.
• Further work will be done by all E&P companies to cut scope and margin in supply chain.
• Some larger scale M&A/consolidation may be expected at this point in all sectors.