By January, the price of oil had fallen to $52 per barrel and in the course of January it fell below the $50 mark. In November when the Organisation of the Petroleum Exporting Countries (Opec) gave up any semblance of controlling oil markets, the price had been $75. In mid-June it had been $107. Furthermore, because the price is set in a competitive market, prices are likely to fall further. If the oil price falls below the point at which it is economical for companies to extract it, supply is immediately constrained as producers reduce their production. Other things being equal, prices then rise.
While this period of sharply lower oil prices has focused much attention on producer governments such as Russia, less has been said about the impact on private international oil companies (IOCs). Before the price collapse, they were already struggling to keep shareholders happy. Their business model consists of maximising oil reserves and increasing production at almost any cost—but this approach was already under pressure given financial markets have lost interest in long-term, high-risk upstream oil ventures. Thus much lower prices have serious consequences for oil companies.
It has damaged their cash flows. Fadel Gheit, an energy analyst at Oppenheimer, quoted in the Financial Times, argued that a price of $65 gives ExxonMobil a shortfall of some $15bn per year. This seriously affects companies’ ability to pay higher dividends or indulge in share buy-backs. Wood Mackenzie, the energy company, has estimated that at $60 per barrel, only three out of the top 40 companies have sufficient free cash flow to cover their spending, including dividends. As for the smaller exploration and production (E&P) companies, at current prices, many are already making losses and many are not generating any revenue at all.
This could lead to a spate of takeovers and mergers. However, the takeovers of the late 1990s following the last oil price collapse of 1998, failed to deliver much value for shareholders and ran into significant competition issues in the downstream forcing major divestments. More such mergers would not impress shareholders. However, smaller companies could present attractive targets for those companies with some free cash flow.
Existing pipelines and platforms are ageing and many are reaching their sell-by dates. Oil that is not extracted in the next five to 10 years is likely to be left stranded.Exploration and development projects are already being cancelled or postponed. The eventual number will depend upon their break-even price. This is the price that covers the full cost of a new project including an acceptable return on capital. For shale oil operations in the United States, this has been estimated between $60-90, although this is overstated as the recent shale oil boom has caused some cost inflation. As the boom is brought to a halt by lower prices, break-even prices fall. Exploration is particularly at risk as it can be postponed with little if any negative impact on immediate cash flows. In a financial world where short-termism clearly now rules, this presents an attractive option.
However, lower capital expenditure presents threats to future oil supplies, suggesting a possible future price spike. In this context there is a particular problem for the United Kingdom’s North Sea. The economics of production there depend heavily on using existing infrastructure to exploit new oil fields. Most new finds and developments would be uneconomic if they have to invest in their own infrastructure. Existing pipelines and platforms are ageing and many are reaching their sell-by dates. Oil that is not extracted in the next five to 10 years is likely to be left stranded. At current prices, let alone if they go lower, without a dramatic easing of the fiscal regime, this would apply to much of the North Sea’s remaining resources.
Of more immediate concern to companies’ cash flow is the shut-in price. This is the price at which existing producing fields are shut down—for US shale oil this is somewhere below $40. This would immediately reduce supply, which would possibly help to revive oil prices. However, companies facing large debts, which is the case for many US shale oil producers, desperately need cash flow to repay the banks and they would be reluctant to cease production. It is quite likely that many small to medium sized operators will go bankrupt in the near future—those that do not will come under further pressure in the course of 2015 if interest rates rise.
Overall, a low oil price is bad for the oil companies: many of the smaller ones will go to the wall and the larger ones will have to divest themselves of poorly performing assets.
However, the greatest threat is that these private companies already face a manpower crisis. Their ageing workforce is not being replenished as potential bright new entrants look to renewables and cleaner energy rather than “dirty old oil.” If the current low price world damages what remains of the highly-skilled workforce, this could presage the death of the industry.
