The oil price crash and its effect on the market and world economies

WHAT, IF ANYTHING, IS DIFFERENT?

JOE BANNISTER, HOGAN LOVELLS, LONDON

NO ONE with any interest in or knowledge of the oil and gas industry can deny that the present market conditions are anything other than challenging. However, oil price volatility and the problems it creates at the pumps, on the rigs, and in the markets is nothing new. Dependent upon one's age and perspective, the present turmoil is merely another example of the sort of disruption and havoc played on corporate and personal budgets by the 1970 energy crisis and its aftermath. From the mid-1980s to September 2003, the inflation adjusted price of a barrel of crude oil was generally less than US$25 per barrel.

A series of events, most notably the second Iraq war in 2003, led the price per barrel of oil to reach US$75 by the middle of 2006. By late 2007, oil prices were nudging US$100 per barrel with the highest recorded price per barrel of US$147.02 being reached in the summer of 2008. Between 2011 and 2014, oil prices, broadly speaking, averaged US$100 per barrel.

Between late 2013 and the summer of 2015, oil prices became more volatile until December 2014 when the benchmark price for a barrel of crude oil reached its lowest price since 2009 - around US$60 per barrel. Overall, this represented a 40% decrease in oil prices in the course of 2014 - Bloomberg News, 12 December 2014.

In the course of 2015, oil prices rallied to reach a little over US$62 per barrel in late February of that year. In the second half of 2015, oil prices began to fall sharply with Brent Crude recording its biggest loss for a week in nearly two months by mid-October. At that point, oil prices fell below US$50. More efficient production of shale oil in the US, allied to the refusal of jurisdictions such as Saudi Arabia to restrict production and in 2016 the prospective opening up of Iranian oil production have continued to contribute the malaise and price challenges in the production of oil. By mid-January 2016, Brent Crude prices fell to US$27.10. Hawks within the economic departments of certain financial institutions were, at the outset of 2016, predicting a fall in prices to as low as US$10 per barrel. They went on to say that holders of oil and gas stocks should be selling those stocks.

What, if any, is the difference between now - spring 2016 - and the position in the mid-1980s, already referred to, when the average price for a barrel of oil was invariably less than US$25 per barrel?

The blunt answer is the explosion in debt and capital expenditure undertaken by the majority of the world's major oil producers. By the end of 2014, the total indebtedness within the global oil and gas industry had risen, according to the Bank for International Settlements, to US$3 trillion. Much of that indebtedness had been incurred in the period between 2011 and 2013. All of this investment and borrowing had been undertaken in an environment of low interest rates and liberal fiscal policies within international central banks. Emboldened by the prospect of high returns - and concerns about longer term reserves - the production of oil from the shale has risen sharply. It is also suggested that shale wells are more efficient and that the break-even point in all the principal shale regions occurs at prices between US$40 to the low US$50s. That is a view expressed by Rystad Energy.

What does this mean for the oil and gas industry and those serving it? The fallout may differ, depending upon whether one is looking at the position on a micro or a macro level.

In the European market, many companies have come to rely upon what is called "Reserves based lending (RBL)." RBL loans are secured against the value of a company's petroleum reserves and future production. Maintaining - and drawing upon - facilities against an oil price of US$100 or more per barrel is quite a different exercise to seeking, maintaining and repaying credit where the price per barrel lies between US$30 and US$40. Before 2015, companies had hedged against falling prices. Such hedges have been priced on the assumption of a far less substantial reduction in oil prices than that experienced over the past two years or so. Alternatively, hedging protection will be coming to an end - or at the very least becoming difficult to replace - at the levels necessary to offer meaningful protection in the present low price environment.

As RBL facilities come up for renewal or review, lenders are thus likely to insist upon borrowers preparing contingency plans that are likely to cover a range of options from the divestment of non-core assets through to refinancing debt from other sources. That will in turn require detailed analysis of the rights and options open to all stakeholders. This has already led to a number of businesses becoming distressed and to some administrations or bankruptcies - eg First Oil Expro, Iona Energy UK Plc, Iona UK Huntington Limited; and in the US, the bankruptcy of among others, Sabine, Energy Exploration, Samson, and Endeavour.

Turning to the macro, the Gulf States have seen government revenues placed under pressure and budget deficits rising on account of the plummeting oil prices. Moody's predict that Saudi Arabia's deficit for 2016 will be US$88 billion, being roughly 22% of that country's gross domestic product. The Saudi government has funded this budget deficit by turning to foreign reserves. According to the Financial Times, Saudi Arabia's reserves fell to US$602 billion in the year up to January 2016.

According to restructuring specialists Begbies Traynor, the number of UK oil and gas businesses experiencing "significant" financial distress increased from 288 companies at the end of 2014 to 486 in the final quarter of 2015. In the US, 35 exploration production companies filed for bankruptcy protection between July 2014 and December 2015. The distress and increase in bankruptcies or restructurings has been described by some commentators as a result of the industry receiving in effect free credit as a result of the high price of oil per barrel and the benign interest and funding environments. Now, by contrast, Deloitte are pointing to the fact that 35% (about 175) of the publicly listed exploration and production companies, owing US$150 billion in debt, face severe financial distress.

Another contributor to the "perfect storm" of low prices, high indebtedness and spiralling costs is that resulting from the decommissioning of exhausted or expensive oil wells and the removal of the infrastructure associated with them. Decommissioning is a particular issue in the North Sea, one of the most expensive regions for oil production in the world. Production has fallen by some two thirds over the last 16 years. On some estimates, the total decommissioning costs within the North Sea basin are estimated to reach between £40 billion and £54 billion. Wood Mackenzie suggest that spending on decommissioning will exceed that of developing oil fields in the North Sea from 2022.

Against that background, it is unsurprising that many oil companies have now started, year on year, to draw down upon their reserves more quickly than such reserves are being replenished. According to the Wall Street Journal, Statoil replenished 55% of its total reserves, whereas Shell's reserves, without taking account of its takeover of BG Group in 2015, fell by approximately 20%.

The cumulative effect of these changes will be to create challenges and opportunities for corporates, creditors and advisors alike. Returning to decommissioning costs, lenders faced with weakening covenants across the industry will need to decide whether supporting a decommissioning programme is essential to the longer term maintenance of creditor relationships as against merely throwing "good money after bad." Preservation of cash and the negotiation of flexible supply and labour arrangements will be crucial to the maintenance of viability and the production of acceptable returns, particularly in expensive areas such as the North Sea.

The increasing linkage between oil and gas prices and stock market performance along with the attendant concerns that generates for the smooth functioning of the market will challenge governments and regulators alike. Rigorous management of day to day operations and new projects are likely to be increasingly critical components to the survival of businesses, let alone for business expansion. The development of the infrastructure needed for any successful new oil and gas production field or region will need to be more streamlined and less bespoke if it is to be viable. Suppliers and consultants are therefore likely to face the kinds of demand for commoditized and cost effective services that have in the past decade or so transformed much of the automotive industry.

There is likely to be continued deal activity in all sectors of the market as larger companies with strong balance sheets seek to divest themselves of non-core assets as they focus upon their core businesses. Lower returns in all sectors of the market will place a premium upon integration and the economies of scale to be achieved by the effective use of technology.

All that said, there is perhaps some force in the view that the current uncertainties, market and price volatility need to be kept in perspective. As has been stated on a number of occasions, the oil and gas industry has "been here before." The current depressed state of the oil and gas market, with its supposed "new normal" of sub US$50 prices per barrel, is merely a reflection of the market having moved "full circle." In such an environment, fortune is likely to favor the brave and the well prepared, whether those hardy souls are corporates, their financiers or the advising and consulting professionals who service this industry.

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