The collapse of crude oil prices in the second half of 2014 caught many by surprise. The price of Brent crude fell more than 50 per cent from $115 per barrel (bbl) in June to below $50/bbl by early January in 2015 and shows no sign of reaching the bottom just yet. For four years up to June 2014 oil prices had remained consistently above the $100/bbl mark, which the Saudi oil minister, Ali Al-Naimi, viewed as the optimum price to balance the market between crude oil price producers and consumers.

The last fall of this magnitude was during the financial crisis: in July 2008 prices were approaching $150/bbl, but had plummeted to below $50/bbl by the end of the year. This dramatic price collapse was in response to severe recession in many countries. However, the fall proved to be temporary and oil prices were back up above $100/bbl by early 2011. 

Figure1. Bent Crude in freefall since June 2014

The causes of the current prices collapse are not as dramatic. There has been no major world economic shock. Indeed the world economy is growing, although the recovery is not as rapid or as widespread as many have hoped.       

So why have oil prices more than halved? And what impact will these have on company finances in 2015? After years of relative stability, giving rise to confidence and investment in the oil and gas sector, major uncertainty is now significantly impacting the financial outlook for investors, governments, operators and service providers. 

Why has this happened? Because supply growth…

While growth in global demand has been subdued in recent years, supply from mainly non-OPEC producing countries has increased leading to a surplus of oil in the market. In a November 2014 analysis, Citibank estimated that supply was exceeding demand by 700,000 barrels per day (bpd). This resulted in a build-up of oil inventories. For example, crude oil production in the United States has increased significantly in recent years: the country produced nine million bpd in 2014 compared with five million bpd in 2008 (see Figure 2). This has been possible because years of historically high and stable crude oil prices made shale oil projects, principally in North Dakota and Texas, economically viable.
 
Global oil production and Brent crude price

Figure 2. Why has this happened

The mission of OPEC, as stated in its charter, is “the stabilisation of prices in international oil markets”. In the past, when oil prices were falling, OPEC would usually intervene in the market by cutting output to support prices. However, at its last meeting in November OPEC responded to the current surge in supply by maintaining production levels. At the time of the meeting the oil price was just over $70/bbl. In the three weeks following the Vienna meeting prices fell by a further $10/bbl and triggered a near ten per cent sell-off of crude inventories in a single day.
Many OPEC countries in the Middle East have taken advantage of the low costs of onshore oil production. As shown in Figure 3, the average cost of extracting oil from onshore fields in the Middle East is $27/bbl, less than half the cost of extracting North American shale ($65/bbl).
 
Figure 3. Average cost of crude oil production

Source: Rystad Energy, Morgan Stanley Commodity Research estimates

While the move to maintain current levels of production may sustain OPEC’s market share, it will increase pressure on high-cost producers, particularly in North America, who have increased production rapidly in the past decade. At present OPEC accounts for roughly one-third of total global oil production.

…failed to meet demand expectations

Although the global economy continues to recover, growth has been weaker and slower than many expected. For example, softening Chinese growth continues to cause concern and growth in Japan and the Eurozone remains fragile at best.

Total European crude oil consumption fell to 14.3 million bpd in 2013 from 15.3 million bpd in 2009, and 2014 levels may even be below 2013 figures. European economies are still grappling with weak growth and low inflation, making the threat of a third recession in six years a real possibility. Indeed, the European Central Bank announced that inflation in December was -0.2 per cent. On January 15, the Swiss National Bank suddenly revalued the franc by removing a 3 year cap put in place to shield Switzerland from the Eurozone’s sovereignty crisis, which is likely to trigger other monetary policy changes.  The challenges are similar in Japan, where demand has dropped from five million bpd in 2007 to four million bpd in 2014. If households in Europe and Japan are encouraged to save by the prospect of cheaper goods tomorrow and companies delay investment for the same reason, then economic growth will come under further pressure.

Source: Consensus Economics

Lower operating cash inflows will inevitably lead to capital expenditure cuts and the potential write-off of exploration assets. In December, when crude oil was trading at $70/bbl, Goldman Sachs estimated that almost $1 trillion of spending on future oil projects was at risk. Similarly in Australia, gas assets are increasingly valued in relation to global gas prices through the LNG trade, values for which are linked to the global price of oil.

Oil and gas companies, as well as the services companies active in the gas sector, thus face a number of pressing challenges ahead:

• Reduced operating cash flows may ultimately result in business failure, so company boards will need to give greater consideration to judging whether the going concern basis of accounting, (i.e. whether the company is able to continue trading for the foreseeable future) is appropriate.

• Renegotiating debt will be challenging. Lower asset values and increased default risks mean that borrowers may face higher interest rates or enhanced security packages, if they are able to borrow in the first place, and accelerated debt repayment schedules.

• Increased threat of takeovers. Volatile commodity prices increases mergers and acquisitions activity. For example, Repsol acquired Talisman in December and Baker Hughes purchased Halliburton in November. When cash flow problems are present, corporate purchases can take place at bargain prices as a result of investors being forced to exit their investment quickly and realise cash at any price. 

• More use of hedge accounting. With prices consistently above $100/bbl, most exploration and production companies were able to make profits without needing to hedge. However, many companies, especially large players, continued to pay for price hedging instruments as ‘insurance’ against a price fall. Lower prices may mean more producing companies, including smaller ones, could resort to ‘locking down’ their output with hedging instruments. Hedging instruments may become effective for accounting purposes, and companies that have maintained price hedges (for instance, for a price floor of $80/bbl) will find that these are now ‘in the money’. After an extended period of taking ineffective volatility through the profit and loss account, companies which adopted a policy of hedge accounting may need to take part of the gains through hedging reserves for the first time in years. For purchasers of fuel such as airlines, miners and transportation companies with hedges in place to cap prices, the effect will be the opposite and hedges become ineffective.

• Greater counter party risk. Lower commodity pricing leads to credit risk where counterparties are dependent on oil prices for cash flow, as with a large ongoing capital project. Where a company is part of a joint venture (JV), there could be an increased risk of JV partners being unable to fund their share of liabilities (including decommissioning costs), and this could result in other partners having to take on their share, putting increasing pressure on their own cash reserves.

Conclusion

The oil price collapse has given rise to a high level of uncertainty, which is being reflected in company balance sheets. After years of relative price stability, investor confidence in the oil and gas sector has plummeted, and for the moment there is little reason for confidence to return. The question most asked in the industry is whether this is ultimately a long-term downward structural adjustment in the price of oil or a short-term temporary correction. A number of recent analyst forecasts confidently point to a recovery back up to $80/bbl by the end of 2017. Whether they are right or wrong, the continuing uncertainty means that 2015 certainly looks like being a hugely challenging year for oil and gas companies, oil producing countries, global policymakers and the services sector.

Authors:
David Holtam (Deloitte UK), Hassan Bashir (Deloitte UK), Geoffrey Cann (Deloitte Australia)