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What a difference a few months can make: how to respond to the oil price drop

For five years, high energy prices drove strong capital investment and strong profit margins throughout the industry. Those same economics also encouraged technical innovations that led to a rapid oil production increase and an increasingly oversupplied energy market. At some point, the market had no choice but to ‘right’ itself.

Kevin Smith and Mark Routt
KBC Advanced Technologies
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Article Summary
Within hours of the end-November 2014 decision by OPEC to renounce its traditional market-balancing role, the world changed. A perceived global oil ‘oversupply’ situation was now confirmed and oil prices plunged more than 50%. These lower prices turned the industry on its head and all those fourth quarter business plans into so much scrap paper. Next came the inevitable question, “What do we do now?” To answer that, we first need to look at what we know and what we believe to have a basis for determining a way forward.

What we know
• The drop in oil price to around $50/bbl has removed approximately $2 trillion of working capital value from the oil and gas industry balance sheet.
• Many, if not virtually all, oil and oil service companies are actively cutting operating costs, chiefly through staff reductions and budget cuts.
• Many new (i.e. not yet sanctioned) upstream projects are now on hold, but current production is not likely to decrease until it becomes uneconomic on an incremental cost of production basis.
• OPEC (Saudi Arabia) has publicly stated they have no intention of curbing production and will instead defend market share—down to $25/bbl if necessary.
• Other OPEC producers have clearly heard the message and are ‘toeing’ the same line; monthly Official Selling Prices are all marching lower in lock-step as price action is taken by producers to defend that market share.
• Oil in storage (floating and onshore) is rapidly growing as many capitalise on a new market structure, but inventory increases only move the supply overhang out in time and do nothing to resolve it. Storage capacity is limited and will soon be full. That’s when the real issues will be revealed.
• Global refining margins are now lower, but still at historically positive levels.

What we believe
• Modest increases in global product demand alone will not clear the supply imbalance. Non-OPEC production will soon have to shut-in as storage fills to capacity.
• Net oil exporting countries are now facing budget deficits, currency volatility, risk of recession, and increased borrowing costs as economic activity stalls.
• Operating companies with significant upstream exposure face a number of critical issues: asset and balance sheet write-downs, debt servicing concerns, share price corrections and a revisit of dividend policy.
• To maintain cash flow and current revenue, upstream companies will resist trimming current production, but output will be cut at a point based on individual cost of operations, or by an external market physically incapable of storing or consuming incremental production.
• Refineries, particularly for integrated businesses, will also curb capital spending programs. A few may also be able to avoid operational budget cuts, but with positive refining margins, downstream operations will have to carry more than just their own costs.
• Today, the price of oil has temporarily bottomed, but there are far more risks to lower, rather than higher oil prices. For example, product demand growth could be undermined by any number of economic disruptions. Alternatively, some OPEC members could increase production even further. In particular, additional supply could soon come from a return of Iranian oil. By contrast, there are few, if any, foreseeable events that could spur a rapid increase in the oil price.
• Our view is that 2015 will see prices remain volatile, but average at or below $50/bbl, with a gradual rise in Q4. Price volatility will continue into at least the first part of 2016 until product demand slowly grows and the inventory overhang we are building today is cleared. The real risk to that price view is that it will take more time to resolve the supply/demand imbalance, and consequently, the upstream producer is facing a prolonged fight to be the last one standing.
• While the focus today is on the impact of lower energy prices, we are also sowing the seeds for our not-too-distant energy future. Future upstream investment programs are now being cut, but the very production that was meant to generate in 2016, and onward, will be sorely needed as global demand grows. For this reason, we believe the long-term, inflation-adjusted cost of energy can only increase from the lows we are creating today.
• While refining margins are positive and holding for many parts of the world, the medium-term impact of current prices will be a rebalancing that could easily drive a wave of new refinery closures in Europe, Japan and possibly US Atlantic Coast.

What this means
Now to answer the “so what?” question, likely the most discussed issue in our industry today. This warrants an answer that will dictate the future of our industry. Simply put, the answer is dependent on how you are positioned in the market and your cash versus debt position at the close of 2014. Every organisation has its own unique challenges and opportunities, but there are some globally consistent themes that should form a basis for one’s corporate strategies. That likely includes a revised 2015 operating plan to get you through the short-term, and a fresh strategic plan to establish a foundation for the inevitable wave back up as prices stabilise and finally increase.

To more crisply reflect these general themes, let’s address the “so what?” for each sector: Upstream, Refining and Integrated Oil.

the immediate impact of lower oil prices is an obvious curtailment of capital investments. However, the reality is, for many upstream businesses, high oil prices and record profits have masked rapidly increasing operational costs that actually eroded critical business fundamentals.

The short to medium-term focus for all upstream companies needs to be on re-anchoring the fundamentals of their business to proven, effective industry practices that maximise revenue and profitability. The result of that attention will be more financially efficient production of existing producing assets.

A client recently summed this theme up by saying, “upstream producers need to think and act more like refiners.”
We suggest some actions that follow from this realisation:
• Improved asset availability and operational integrity to drive production based on a platform of cost effective reliability
• Production (flow) assurance to optimise revenue generation from existing assets, particularly true for fields pulling from multiple well-heads with variable production
• Target operational talent development to improve production management skill sets
• For organisations with multiple producing assets in the same geography, there is often savings and additional optimisation from managing those assets as a single entity
• Aligning production plans and field balancing to preserve the long-term value of the fields

When capital investment eventually returns, the lesson to be learned from this price plunge is that all new asset investments must also be accompanied by expenditure in the underlying operational and organisational fundamentals critical to running those assets safely, reliably and profitably.
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