Oil rout will drive deals for oil companies
Hugh Ebbutt, Richard Forrest, Vance Scott and Alvin See, of consultancy AT Kearney, weigh up where the action will be as the price plunge shakes up the sector
As we enter 2015, the oil price has fallen well below $50 a barrel (/b), down from Brent’s $115/b highs of late June. The steepest drop has been since Opec’s meeting in late November. It is nearer $40 in the Middle East, and much lower in parts of North America where bottlenecks restrict flows. And oil may yet fall further.
The price has broken through a range of previously expected resistance levels – of $80, $70, and $60 in the week before Christmas – hurdles based on estimated break-evens for Saudi or other Opec budgets and producers in key areas. Analysts and traders, for now, have given up trying to call the bottom or “catch the knife”.
Some are betting Brent could fall below $40. The pressure on cash flow is intense and oil companies of all sizes need to have a clear response to the situation – for both near-term survival and longer term growth. This raises some key questions for the year ahead:
•How long will prices need to stay low to rebalance the market?
•How should companies best adapt to the new environment? How far can operators squeeze costs?
•What to cut and what to keep?
•Will there be a new wave of deals to capture growth positions and scale at low prices or more focus on high margin or lower risk assets to strengthen cash flow and returns?
•When is the best time to move? How quickly will the window close? Will early movers capture strategic advantage or jump too soon?
Everyone is looking for a signal that the rout – the biggest since the 80% price drop in the wake of the 2008 global financial crisis – is over. Will oil recover as quickly as it did then? Or will it be slower, as it was in 1999? The market is now at least in contango (with prompt prices lower than futures). Once a period of relative stability suggests the worst is over, buyers will return and will be looking for good deals.
Current oil supply (approaching 94 million barrels a day [b/d]) is 1.5m to 2m b/d higher than demand (see figure 1). Developments already under way are hard to stop and so will continue to play out and add to the supply surplus. With demand growth of only around 880,000 b/d currently expected over 2015, this over-supply looks set to last for a while.
Demand could grow faster. For this, China and the US are key. With lower prices, US demand will pick up again and there are clear signs of this already – notably at fuel stations. China imported over 7m b/d in December and with oil use up 5% to 10m b/d has taken advantage of sharply lower prices to build its strategic reserves. Concerns about the pace of demand growth there and in other fast developing economies may be overdone. Cities are still growing quickly, and people want the benefits of plentiful energy and mobility. And China’s economy is now much bigger, and is still growing at an impressive 7%.
The Saudis look unlikely to cut supply any time soon. Ali al-Naimi has been very clear: they have plenty of financial reserves to maintain domestic spending, and are able to withstand the price drop, even if oil falls into a $20 band. Their strategy seems wise: they could either lose more influence and market share – or let the market remember which production comes to consumers at lowest cost. If they had cut, they would still have lost revenue, and then found themselves in a vicious circle, as higher prices held demand back and stimulated even more production from shales and other high-cost plays. Their refusal to cut is also very helpful to the US and other consumer economies, while less so for Iran, Russia, Nigeria and Venezuela.
Surprise events and political unrest leading to cuts in supply will occur. But the market shrugged off the impact of the terminal fire at Es Sider, in Libya, and it may now take a larger disruption to trigger a real rebound. So, until around 1.5m to 2m b/d is taken out of supply or added to demand, prices will need to stay low for a while – probably most of 2015 – to bring them back into balance.
With self-imposed Saudi-led Opec cuts unlikely for now, North America becomes the key swing producer. US output is now more than 9m b/d, up 80% from 2007. It is this growth that has largely caused the price collapse. Shale producers can rapidly dial down drilling in a matter of weeks and can crank it back up again just as fast when prices rise, as they will.
Sharply lower oil prices will cut activity and reduce break-even prices (figure 2). As spending and activity is cut, service companies will lower pricing to maintain utilisation. Canadian oil sands and non-core shales are being cut already.
US shale producers are cutting 2015 spending by up to 50%. But so far their output is still higher than a year ago. Break-evens are lower in the core areas of the best plays (perhaps $45-50/b) – and are lower for the most efficient operators. They will fall further – perhaps by as much as $10/b or more – as rig, freight and other rates fall and as experience makes drilling, logistics and fracturing more effective.
But, in early January, sweet crude from the Bakken fetched less than $32/b, and sour crudes less than $23/b. If these price levels persist, as leading analyst John Kemp points out, there are very few parts of the Bakken, whether in core sweet spots or on the periphery, where drilling new wells makes financial sense. Prices in the two other major US shale plays – the Permian and Eagle Ford in Texas – are perhaps $10 higher, but the story is similar.
Most small and mid-sized shale independents rely on lenders to finance their new wells and already carry a high debt burden. Both now need to hold on to their cash and stop drilling likely loss-making wells. Without hedging, this would be most of them at current prices. With a lot of production hedged out for six months or more, US drilling in mid January was down, but so far only by about 15%, from record high levels in late 2014. It is soon likely to fall much further.
Meanwhile production from the many recently drilled wells is still economic. The US Energy Information Administration (EIA) expects production to rise over the next few months as these are brought on stream. So, even with 60-65% declines over the first year, it may take months, if not most of 2015, before shale output really falls off. If wellhead prices stay low for long enough, even with more exports, some of the 400,000 very low-margin US stripper wells will be shut in, reducing their 700,000 b/d yield.
Cycles of boom and bust are driven by political changes and phases of over- and under-investment – from shales to deep-water, with lead times of a few months up to 10 years. Now it is likely to be what happens in the US which primarily drives the near-term trajectory of global prices.
For oil companies, the problem is that many have been spending more cash than they earn. Costs have risen and now prices have more than halved over the last few months. In 2015, many will have to raise debt to fund dividends and planned investment for growth.
Even when oil traded at over $100/b over the last three years, oil companies consistently needed to borrow to cover their outlays. For example, in 2013, BG Group’s dividend and capital expenditure exceeded cash flow by 47%, while Eni’s was by 59%. This model is unsustainable.
Majors were already trying to shed the higher-cost assets in their portfolios to improve cash flow and returns. US independents, who had been big buyers of international positions, sought to shed these to refocus on the growth and more reliable returns of domestic shale.
The industry is embarking on a very challenging year. Most companies are rapidly exploring how to address intense cost pressure. By mid January, more than 40 companies had announced capital expenditure plans for 2015, with an average reduction in spending of more than 30% (and often more for smaller independents), with many people about to lose their jobs. More cuts are inevitable.
Cash will be key. Near term spending will be cut most. High cost, slow payback and less economically robust projects that have not yet reached final investment decision will be cut or deferred, even though prices are likely to be stronger once these developments are on stream. With fewer projects at a more measured pace, operators will be able to design and plan projects more effectively and really drive their costs down.
Exploration in frontier, deep-water, and other high-cost areas (like the Arctic) will be drastically cut back. Service companies will experience a sharp drop in demand for expensive drilling and capital projects, and will need to get their own fixed costs down fast.
This will hit these contractors and their suppliers hard, and job losses are already looming – from Aberdeen to Mexico. For the North Sea and similar mature offshore provinces, tax breaks or incentives will be essential to keep investment and jobs, before aging fields are shut down.
Seize the opportunity
Mergers and acquisitions (M&A) strategies will also be a crucial part of the solution for many. The price drop is unlikely to last forever, and opinions of how long it will last are still sharply divided. This creates opportunities. As one chief executive said: “Buyers need to be brave and go countercyclical, as the next 18 months will be fairly unique.”
For those with cash to invest and healthy balance sheets, the next few months will offer great opportunities to buy good assets. Others will need resilient strategies just to survive. Well-targeted acquisition strategies will enable first movers to access attractive assets at lower cost – and with much less risk – than much of the previously planned frontier exploration.
With debt pressures mounting and some independents’ share prices falling more than 50%, some of these assets are already very good value. The time to move is now.
The window of opportunity may be shorter than expected. Buyers are already assessing who is in trouble and how long they can stick it out. They are reaching out and quietly making themselves known to potential sellers. Sellers, in turn, are preparing their defence positions and looking for the best ways to survive the trough.
As soon as prices settle and valuation expectations between buyers and sellers start to converge, companies with clear shortlists of what they want will start moving to capture these key assets. Some may simply go hostile on smaller targets. It often takes three or four months to get a deal through, so there will be a lag before the wave of new deals is announced.
To secure the seller’s agreement, buyers may have to offer higher premiums against the seller’s now much lower share price, perhaps 50% or even more, as Repsol recently have for Talisman, instead of 30%. Many deals will be done with stock rather than using much-needed cash. Longer term upside benefits will then be shared by both buyers and sellers.
Stronger shale players in North America are likely to continue leading the way. According to PLS data, US and Canadian companies nearly doubled the value of upstream deals agreed to $125bn in 2014, while international deals fell 21% in value to $60bn.
But not all is rosy in the wider independent sector. Some firms are still sitting on what were marginally profitable assets at $100/b, having over-invested in volume growth during the boom years. These players may be vulnerable and interesting acquisition targets (see figure 3).
The diversity of portfolio and financial strengths in the independent segment means M&A strategies and targets will vary. The winners will be those with the cash flow and balance sheet strength to take early action on portfolio high grading — either selling production to de-risk the low oil price or taking advantage of the situation to capture bargains as weaker competitors struggle. Independents who have taken on high debt and have low cover for capital expenditure and dividends, especially those with many high-cost assets, could end up in distress (see figure 4).
All international oil companies are now striving to focus their portfolios to cut near term costs and maximise cash flow and returns, so are likely to shed more high-cost assets. Previously their key drivers for acquiring assets were accessing unconventionals, reserves growth and scale. Now they will need to revise the prices used for evaluation scenarios to sanction projects. The big players, with strong balance sheets, scale and downstream or other businesses, are likely to weather the oil price plunge. They will cut or defer near-term capital expenditure, reduce headcount, sell assets they don’t want and focus on a smaller, simpler set of upstream projects with lower costs or better margins. Those with big war chests will strategically look to take advantage of the buyers’ market.
Drivers for national oil companies vary by region and type, and include the political agendas set by their governments. Chinese companies spent $24bn to buy 17% of global assets traded in 2013. Last year this was down to only 4%. Similarly, PLS data show other Asian companies only spent $4 or 5bn in 2014 down by half from 2013. Most have been busy digesting and extracting value from their surge of resource acquisitions over the past few years.
Buying resources is now likely to be more carefully targeted as these companies learn from their previous acquisitions. Some may be encouraged to invest or partner with distressed companies or assets, or where geopolitics are a barrier for other investors.
Parts of the oilfield services sector now urgently need new capital and restructuring. Some are ready for further consolidation. Large players may make strategic and scale synergy moves, as Halliburton have with Baker Hughes. Engineering firms could also make strategic moves further into the service sector ready for an upturn.
Financial investors, such as private equity and master limited partnerships, have been active in the US, getting steady incomes well above current interest rates from producing assets. Now that values have fallen sharply and the oil price outlook is so uncertain, some may get more cautious. But both the independent and service sectors currently offer opportunities at good prices for capital still available.
A lot will happen in the year ahead. For some, the shakeout will be painful, but for those in the driver’s seat, it is a rare opportunity to reshape the competitive landscape to their advantage.
What is not clear is where oil prices will go – over 2015 or beyond. Views are divided, and there is a tendency to overweight recent trends. A partial recovery may be quite quick – similar to the V-shaped rebound in 2009 -- or more gradual, as it was in 1998-99, which led to a series of mega-mergers. How resilient will US shale be to lower prices? If the EIA’s recent supply forecast is a good guide, it may only be towards the end of 2015 or even early 2016 before we see oil output fall – and demand grow – sufficiently for prices to rise significantly.
Gas prices are under pressure too – in Asia, due to a surge of new liquefied natural gas (LNG) supply from Australia, and in Europe, with oil-linked contracts and greater access to LNG, helped by planned exports from the US. It will take some time for both the oil and gas markets to achieve a new measure of stability.
So any price recovery may be gradual and only modest, until we have the next big supply disruption (as sooner or later we will). Longer term, will US and then other shales re-emerge as soon as prices start to recover? Have shales now fundamentally changed the global balance of supply?
If oil and gas prices stay low for much of 2015, M&A activity is set to surge. Cost and cash-flow pressures will be intense for all – and big cuts now will mainly depress supply, and thus raise prices, some years out in the early 2020s. Deal premiums may look big against sharply lower 2015 share prices, but many deals will use equity.
Low prices and an uncertain outlook will present some rare opportunities for those willing to adopt contrarian strategies. The window for the best moves may be shorter than some think. Strategic deals in the months ahead – whether acquiring, partnering, or divesting – will help define the winners in the new industry landscape.
For more information, please see ATKearney
Or contact one of the authors, Richard.Forrest@atkearney.com, Vance.Scott@atkearney.com, Hugh.Ebbutt@atkearney.com