Market forces change Oil & Gas industry environment: Operating below $70 per barrel
Crude oil prices, like those for any other commodity, are driven by market laws of supply and demand. However, several inherent market characteristics make crude oil price highly volatile and difficult to predict; severely affecting oil companies.
Supply and demand are inelastic, fixed costs are comparably much higher to variable costs not allowing for changes in production quantities, while prices are highly affected by geopolitical events that are often impossible to predict. Moreover the oil derivatives market has grown to be 14 times larger than the physical market, often used speculatively for profit increasing volatility.
Historically oil prices fluctuate within a certain price band for relatively long periods of time, until one or more of the forces mentioned above trigger a significant change in the industry dynamics. Typically, geopolitical events and changes in supply or demand have the largest effect, with the latter tending to last longer. And as rising oil prices over the last decade have primarily been driven by increased demand, the current oil price slump is caused by oversupply.
In order to better understand today’s market change, I believe leaders in the industry must ask themselves, and their leadership teams, four questions:
How much is at risk?
Exploration and Production spending rose from $200 billion in 2000, to $700 billion in 2014. This was in response to rising oil prices and technological advances which gave access to new, high-cost Oil & Gas reserves. But that is not the whole story. This rapid growth followed a 20 year long downturn period in the industry. Oil & Gas companies were not prepared for this level of growth, and did not have the operational, organisational and technical readiness required to cope with the increased demand. Rapid growth created the need for more skilled resources than were available.
As a result of all of the above, oil output did not increase in proportion to the increase in CapEx. Since 1999, CapEx for every additional barrel of oil rose by 11% annually. According to a study from Goldman Sachs measuring the top 400 Oil & Gas projects in the world ranked by size, more than half of the cumulative lifetime production was projected to come from projects with a Brent-equivalent breakeven oil price of above $70 per barrel. This means that as currently producing low-cost assets mature and move towards abandonment, projects from this list will be coming on-stream. Therefore the average portfolio of an Oil & Gas company will comprise of an increased proportion of more complex and higher-cost reserves.
Consequently, if the current market environment is sustained many projects will become unprofitable; especially in cases where CapEx is already realised and there is small room for significant changes.
How are companies affected?
Comparing the drop of price of Brent over the last year (-50.46%) with different Oil & Gas company stock indices shows us that large integrated Oil & Gas companies (-16.26%) have demonstrated higher tolerance on the recent oil price drop compared to smaller, specialist companies (-30.10%). The asset portfolios of integrated oil companies consist of a variety of different types of upstream oil projects – many of which are producing low cost reserves – as well as a presence diversified sectors such as refining, marketing & trading, lubricants and chemicals. These factors narrow the exposure of Oil & Gas majors in relation to their aggregate portfolios thus allowing to better absorb the marginal losses from high-cost reserves in the short term. Nonetheless, the impact to majors should not be underestimated as such companies have more risk-averse investors (e.g. pension funds) compared to independents. It might be that some are less affected than others, but the longer this period lasts, the more significant the impact will be for the entire industry.
What the future holds?
Rising oil prices over the past 15 years have steered companies focus towards securing and exploring new Oil & Gas reserves to cope with increased demand. That is fully justifiable, as with oil prices above $100 per barrel, upstream Oil & Gas ranks high in EBITDA margin. But that changed, and will most likely last, simply because oversupply will remain. Producing assets have already realised the CapEx during the Exploration, Appraisal and Development phases. In order to shut down production sites, the price of oil must drop below production cost for a prolonged period of time. Projects currently in development will likely continue, trying to reduce costs in the meantime. Projects that haven’t yet commenced will most likely be postponed.
Regardless of the position Oil & Gas companies hold at the moment, the industry needs to prepare for a new era of more moderate oil prices.
Price volatility will always remain as the drivers explained earlier have not changed, but after the current market turbulence normalises the average price range upon which the price will be fluctuating is expected to be significantly lower than one year ago. The lower that price is, the more projects will be facing difficulties breaking even.
The companies that will be better prepared to cope with these changes will sustain the current market slump and lead the way to growth and development. In an environment where many assets may be operating at profit margin levels closer to zero, the industry needs to find a new modus operandi.
How should the challenge be addressed?
It’s time for senior executives to take a step back and re-think their strategies. Do you still strive to increase production as soon as possible, or would you rather take longer but do it in the most efficient and cost effective way? Do you need to hire experienced people to staff your prospective complex projects, or are you now better off investing in young talent who will be ready to fuel your growth at the next oil price cycle? Should your decision making criteria be any different at $60-70 per barrel? Does your company need to change some of the KPI’s upon which it reports to investors? These are some questions out of the many that arise in today’s market conditions.
Looking for those answers will probably make you realise that your organisation is not set up to operate in this new environment. You feel that the resources and expertise are there, so are the equipment and maybe the technology too, but your organisational system is not quite what it should be. This doesn’t mean that that all the good work done in the past is irrelevant. In the contrary, this is about adapting to the changing environment and steering your organisational strengths towards the right direction.
First define your new strategy and objectives based on the new market conditions. You might need to make changes to your Organisational Structure, Operating Model, Processes, Policies, Targets and more to align with your strategy. The road ahead looks bumpy because change doesn’t come easy. But the benefits certainly are worth the effort; in the medium term sustained profitability and competitiveness of your company. Even more importantly, in the long term, you will have the appropriate tools and level of readiness required to grasp new opportunities as they arise and be prepared to take full advantage of another industry growth cycle when it happens.