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2015-12-29 19:55:00

2016 WILL BE WORSE

2016 WILL BE WORSE

As a miserable year for the oil industry draws to a close, any relief executives might feel will be tempered by the knowledge that 2016 is shaping up to be even worse. 

The collapse in oil and gas prices that began in the summer of last year has already cost hundreds of thousands of jobs, and caused projects worth hundreds of billions of dollars to be cancelled or delayed. Today, the external environment is more challenging than it was a year ago, and the energy companies' ability to cope with tough conditions is diminished.

For oil and gas producers, 2016 will be a year of cost-cutting, restructuring, refinancing when it is possible, and in some cases bankruptcy when it is not. Merger and acquisition activity, which was sluggish this year because of disagreements over valuations, may pick up speed.

Oil and gas producers that have other sources of revenues such as refining and chemicals operations, and that still have access to capital markets, will find life difficult but should be able to survive. Companies that are exclusively focused on production and have weak balance sheets will have done well if they can make it through the year.

The outlook was already dire a year ago. Since then, Brent crude has fallen a further 39 per cent, to about $37 per barrel on Monday, and is trading at close to an 11-year low. Longer-dated oil futures prices have also dropped sharply, making it less attractive for producers to use derivatives to protect their revenues, and raising expectations that crude will stay "lower for longer". Prices for natural gas, which are linked to oil under contracts used in Europe and Asia, have been falling too. In the US, the warm winter weather has helped drive benchmark Henry Hub gas to a 16-year low.

Many of the levers available for responding to weak prices have already been pulled, according to Andy Brogan of Ernst & Young, the accounting firm. "Companies had oil price hedges in place, they had costs they could cut relatively quickly, they had capital expenditures that they could put on the backburner," he says. "A lot of these things are going away."

Oil producers have cut costs through efficiency gains and by driving down the rates they have been charged by their suppliers, the oilfield services companies. ConocoPhillips, the world's largest independent oil and gas producer by market capitalisation, said earlier this month that the cost of land rigs for drilling wells in the US had dropped by 32 per cent over the past year, while the cost of hydraulic fracturing to bring those wells into production had fallen by 38 per cent.

US shale oil producers have also continued the steady improvements in productivity they have achieved in recent years. EOG Resources, for example, said last month it had cut the average time to drill a well in the Eagle Ford shale of south Texas from 8.9 days last year to 7.7 days.

Companies have also been cutting capital spending. BP of the UK said in October it proposed to spend about $19bn this year, down from an original plan of $24bn to $26bn.

Such cuts have helped stabilise the industry's finances. The leading listed oil companies will on average need a Brent crude price of $66 per barrel next year to cover their capital spending, interest payments and dividends from their cash flows, down from $81 this year, according to Wood Mackenzie, the energy consultancy. Before the cost and spending cuts, they would have needed $104 per barrel to achieve that cash break-even.

The break-even level of $66 per barrel, however, still means that at today's oil prices the industry's borrowings are set to rise. The large international oil companies can accept higher debts, but do not want their borrowings to run out of control, and they have started to announce a new round of cost reductions. Royal Dutch Shell, which is trying to win shareholder approval for its proposed takeover of BG Group, said this month it planned a further 2,800 job cuts, about 3 per cent of the combined group's workforce, once the deal goes through.

Falling rates for oilfield services will continue to deliver lower costs for producers as contracts come up for renegotiation. For example, Transocean's Deepwater Champion rig is under contract to ExxonMobil to work in the Gulf of Mexico at a rate of $395,000 per day from November to January, down 41 per cent compared to its previous day rate.

There are, however, limits on how far this cost deflation can go. Charges for oilfield services have to be high enough for providers to stay in business. Dave Lesar, chief executive of Halliburton, argues that rates in the US are already at unsustainably low levels. Companies have been raising productivity, for example by drilling in only the best areas, but there are signs that in the Eagle Ford and the Bakken of North Dakota, two of the three largest shale oil regions of the US, productivity gains are levelling off.

Nor can companies continue to cut capital spending indefinitely without damaging their revenues. This year companies have typically been focusing on projects that have quick paybacks in production, while slamming the brakes on exploration and longer-term developments, but the natural decline of oilfields means that continued investment is needed to stop output falling.

The prospect of tighter supply in the future is laying the foundations for a recovery in oil prices, and companies that have cut costs will be well-placed to benefit. "If oil goes back to $60, things might start to look a lot better," says Tom Ellacott of Wood Mackenzie. "The sector should have reset at a lower cost base."

The one ray of hope in the oil industry's Pandora's Box of troubles is that the greater the cuts in exploration and development spending now, the stronger the eventual upturn is likely to be. The task facing oil companies will be to stay in business for long enough to enjoy that rebound when it comes.

ft.com 

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More: 

OPEC: 2015: $55  

RUSSIAN OIL UP  

SAUDI CUTS BUGET  

U.S. BANKS STRESS: $50 BLN  

OPEC PREDICTS $95

 

 

Tags: OIL, GAS, PRICES

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