A year ago, Global Insight assessed the impact of volatile energy markets, asking ‘what if the price of oil stays low?’ Here, we explore some of the answers, including how the sector’s response to the short-term shock could turn out well in the long run.

The fate of global oil prices has been well documented over the past two years. Everything from America’s self-sufficiency and China’s slowdown to Saudi Arabia’s relentless production and the lifting of sanctions on Iran has been used to explain 2014’s price of $110-plus per barrel plummeting to just $28 per barrel at the beginning of this year.

With most oil exploration projects predicated on prices at a low of around $60 per barrel, the fallout from this has been immense. Companies such as Aberdeen-headquartered First Oil Expro have gone bust, longstanding players like BG Group have resorted to being taken over to survive (by Royal Dutch Shell in BG’s case) and the number of job losses in the North Sea alone is thought to be in the region of 65,000.

While on a human level the impact has been devastating, and continues to be, there is a sense that the harsh reality of a prolonged period of price depression could ultimately turn out to be a positive for the sector.

The question is: will the oil industry learn from the blow it has been dealt or, now that prices have started to rise again, will it simply return to business as usual without addressing its own inefficiencies first?

Amazing reactions

While the price of oil is determined on a global basis, the cost of getting it out of the ground varies enormously across the oil-producing world. In Saudi Arabia, where the oil is located close to the surface, the cost of production is less than $10 per barrel, whereas in the UK, where offshore oil is situated deep below stormy waters, the cost of production is closer to $44 per barrel.

Michael Burns, a partner at Ashurst, notes that this is why in some regions oil companies have been dramatically scaling back their operations through job cuts and asset sales while in others they have been carrying on regardless. ‘It’s the same analysis across the world – how much does it cost to get the oil out versus what it can be sold for,’ he says. ‘The North Sea is a relatively high-cost basin – if you assume that it costs $45 to produce a barrel in the North Sea and the oil price drops to $27 that’s not a very good equation. If you’re in a jurisdiction with lower costs of production then you can take more of a hit before getting to the point where it’s sub-economic. If it costs you $30 to produce a barrel then at $27 you’re still losing money, but if it goes to $32 then you’re making it again.’

Giovani Loss is a partner at Brazilian firm Mattos Filho and Chair of the IBA Oil and Gas Law Committee. He notes that offshore-producing regions such as Brazil, West Africa, the Gulf of Mexico and the North Sea have been heavily affected by the low oil price environment because it has essentially meant they have had to pay to produce.

While the most obvious step to take in such a scenario would be to stop producing oil, 39 Essex Chambers silk Peter Rees QC, the former Legal Director of Royal Dutch Shell and current Chair of the IBA Corporate Counsel Forum, says this is not an option due to the long-term nature of contracts in the industry. ‘The upstream commitments of the oil majors were put in place and are fundamentally unchangeable for four, five, six years,’ he says. ‘If you take a company like Shell, which has had an annual capex of $30bn for the last five years, there’s very little it can do about most of that. The only way to cut costs in the short term is to look at the labour force. You can decide not to continue with an investment, but the cost savings won’t appear for a few years then the price of oil will go up and companies will wish they had been investing.’

That explains why the North Sea in particular has suffered such heavy job losses, with BP, Chevron, Petrofac, Shell and Talisman Sinopec among those to slash their headcounts in the region. The move could be shortsighted though, given that production in the region has not stopped and projects designed to exploit the North Sea’s remaining assets will get underway as soon as the oil price has sufficiently recovered.

Paul Stockley is Head of Oil and Gas at Bond Dickinson and Vice-Chair of the IBA Oil and Gas Law Committee. ‘The industry is amazingly reactive to the oil price,’ he says. ‘When it drops they start to reduce headcounts because they can say to their shareholders “this is what we’ve done”, but in two years’ time when things get moving again they’ll need to go on a massive hiring spree.’

Yet the job losses are all part of a major correction in a sector that had become dangerously overheated.

Profligacy or profits

The oil industry is used to fluctuating prices – from a low of just over one dollar in February 1946 to a high of $145 in July 2008, the cost of a barrel of crude has varied widely over the past 70 years. In the run-up to the 2014 crash, however, the industry had enjoyed a long period of relative price stability and this, says Bob Ruddiman, Global Head of Energy at Pinsent Masons, seemed to lull many in the sector into a false sense of security.

‘The industry had gone through a relatively long period of relatively high oil prices –during the global recession the oil industry wasn’t immune, but it wasn’t as badly hit as other sectors so there were about 12 years of relative stability,’ he says. ‘That’s not a generation, but it’s a good chunk of people’s lives.’

As a result the industry – exploration and production (E&P) companies in particular – let costs spiral out of control to the point of unsustainability. Philip Rodney, Chairman of Scottish law firm Burness Paull and Development Officer of the IBA Senior Lawyers’ Committee, notes that the oil industry was reputed to have become so profligate that practically every piece of equipment it used had become bespoke. ‘One example was that there was something like 250 different types of drill bit when there are only five sizes that are necessary,’ he says. ‘I think there’s an acceptance that things were overheated and there needed to be a rationalisation.’

Stockley agrees, noting that the lower-price environment has forced the industry to work in a more efficient manner, not only by shedding jobs, but by finding more collaborative ways to work. ‘I’ve heard people say that at $50 a barrel the oil price is beginning to get more sensible because the cost base got out of control at $110 to $115 and that encouraged inefficiencies,’ he says. ‘As the cost base has come down, the efficiencies have gone up.’

Yet while there are signs that the industry has made a concerted effort to get its house in order, it is still hugely susceptible to movements in the oil price. For Sverre Tyrhaug, Managing Partner at Norwegian firm Thommessen, this shows there is still much to be done before the industry returns to a true position of health. ‘We’re still in a transitional phase,’ he says. ‘There’s a clear need for consolidation because there’s still overcapacity with current activity levels. The sector is heavily indebted and when that debt falls that will be crunch time – either the oil price and activity levels will have come back up again or there will be more defaults.’

From firefighting to facing the future

The jury is out on how quickly oil prices will rise and at what level they will ultimately stabilise. Rees notes that ‘by and large people won’t get comfortable until it’s somewhere above $70’, while Ruddiman says that ‘people could work with a sustainable oil price in the high $50s to mid $60s’.

 ‘If it continues at $50, it will be an adjustment to operate in that environment,’ says Ruddiman. ‘What’s more important is a period of stability rather than an absolute number – we need a sustainable oil price for people to make investment decisions and to service debt. It’s about finding a way to work in a lower-price environment.’

Despite this, there is a general consensus that, having bottomed out at the beginning of 2016, oil prices are now on a definite upward trajectory. This, says Loss, means that rather than simply firefighting, companies can now begin to engage in the kind of corporate transactions that should put them in a better shape to face the future.

‘I would expect oil prices to be between $60 and $70 by the end of this year and go higher next year,’ he says. ‘At one point people were thinking it could go to $15 or $20, which created a very bad mood in the industry – companies panicked and fired more people than they should have. Now we’re in a situation where everyone is patient and calm and can wait to see what’s going to happen and make decisions in a less panicky way. There’s been a lot of difficulty in finding common ground between buyers and sellers – when the oil price was $40 the seller would say it was going up to $60 and the buyer would say it was going down to $20. Now it is going up again it makes no sense to say it’s going to $20.’

With the oil supermajors rationalising their portfolios by, for example, reducing or divesting their portfolios in the North Sea, there has been a change in the kind of players operating in the sector too. This, by definition, brings greater efficiency to the market. ‘There’s been an element of the majors selling off assets that no longer meet their financial criteria for returns,’ says Rees. ‘The North Sea is no longer populated just by BP, Shell, Total and Exxon – there’s a huge number of smaller oil companies or joint ventures that have bought into these fields. Large multinationals have huge overheads and have to allocate them across their assets so the cost for big companies is greater than for small companies, which can be flexible.’

The downside is that the smaller companies are often at the mercy of the bigger players they are buying the assets from, meaning many of the deals that could truly transform the sector still aren’t being done. ‘There are lots of new entrants, but they tend to be small,’ says Stockley. ‘That makes transactions difficult because when big companies are exiting they want to leave the asset behind, but they also want to leave the decommissioning cost with the purchaser. If they aren’t a big player their ability to fund that future decommissioning liability is low. That’s been a killer of a lot of deals and continues to be.’

There is no doubt that the effects of two years of plummeting oil prices have been devastating for the North Sea and other
oil-producing nations in West Africa and South America. However, with the fall forcing all players in the market to reassess their models, Ruddiman says the industry has the potential to emerge from the crisis bruised, but not beaten.

‘From a UK perspective there’s been a lot of pain with job losses and corporate failures and that’s devastating for anyone involved, but you have to remember that the light at the end of the tunnel is that there are still very significant reserves worth producing and there is still plenty of intellectual capital to export,’ he says. ‘I see the future as a more efficiently run and coordinated domestic industry.’

Will oil companies really learn from this and emerge as leaner, more efficient and more competitive machines? Dag Kaada, Managing Partner at Norwegian firm Schjødt, is not so sure. ‘The long-term impact should be that the oil industry becomes more competitive and able to maintain businesses with lower oil prices, but oil companies are very short sighted – when the oil price goes down they throw everyone out and when it goes up they need more people,’ he says. ‘The oil price has gone up and down since oil was found and oil companies have always reacted in the same way. They are either full-on or the brakes are on completely.’  

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Margaret Taylor is a freelance journalist and can be contacted at mags.taylor@icloud.com