When the oil prices began falling from $115 a barrel in June 2014 to the low $30s in February 2016, oil companies were forced to enter a period of major restructuring which saw them adopt a new low-cost strategy. The cost-cutting lead to major job cuts, with the trade body Oil & Gas UK reporting 120,000 less employed in the North Sea compared to 2014 levels. Big Oil, however, has seemingly adjusted well and found stable ground amidst rising global demand, growing geopolitical tensions and a well-performing world economy – driving a rally in the global oil prices.
Key Factors Aiding the Rise in Oil Price
The oil rally can be largely attributed to the production cut agreement by OPEC and other producers, such as Russia, since January of this year, reducing the daily global output by 1.8m barrels per day. The cuts caused a tightening of the market and helped ease out the supply glut caused by high US crude outputs and are expected to be extended during the next OPEC meeting in Vienna later this month.
Russian Energy Minister Alexander Novak met with Saudi King Salman and announced that these cuts could be extended beyond the March 2018 deadline, further pushing the optimism over price forecasts. In addition to production cuts, growing geopolitical tensions in Iraq have further extended the positive outlook for oil.
Following a referendum in favour of independence by Kurdistan, Turkey threatened to turn off the BP-operated Ceyhan pipeline, which if executed could choke global supply by 500,000 barrels per day. As tensions continue to escalate, analysts are forecasting higher oil prices, especially if Turkey acts on their threat.
Further fuelling the oil bull is the strongest period of global economic growth and expansion since the bounce-back of 2010, according to the IMF, with growth expected to rise to 3.6% – from 3.5% last year – and further in 2018 to 3.8%. The IEA also reports an increase in global oil consumption by 1.6m barrels per day, helped along by well performing emerging markets that are taking advantage of the cheaper fuel on offer.
The demand/supply outlook going into 2018 is likely to balance out as tightening of the market eats further into global inventories. Prices are further bolstered by a drop in total U.S. crude inventories, despite an increase in the total output; a statistic attributable to the growing paradigm shift amongst shale producers from a ‘grow at all costs’ attitude to ‘lower for longer’. A sentiment both shared and welcomed by oil majors.
Bumper Returns on Profit
The culminating effect of oil’s rally is that oil companies are finally able to enjoy the fruits of their cost-cutting labour. Before the oil market crash, most oil companies had a break-even between $60-70. But, when the oil price dropped to below $30, something had to give. The unfortunate casualty was high upstream capital expenditure projects, such as the newly commissioned deep-water drilling projects.
This forced companies to go into a three-year transitional period where they adapted to the new ‘lower for longer’ model, where the emphasis was on lowering the break-even to below $40 a barrel and being ready for any price point. There was a strong focus on reducing net debt and achieving a stronger cash flow despite a low-price environment. As a result, M&A activity during this period was at a record high, due to companies looking to refocus their asset positions to more strategic and low-cost developments.
In fact, Deloitte reported that asset-based M&A deals accounted for 72% of total activity for the first half of 2017, a figure expected to rise with M&A activity not limited to just upstream, as oil field services and midstream deals pick up the pace. Investment during this period was also down, with IEA reporting global upstream investment falling by 26% in 2016.
Last week saw most of the top oil majors receive almost double profits in their third-quarter results. BP, Shell, Total, Chevron, and ExxonMobil all recorded profits surpassing the forecasts, with Shell exceeding their analyst forecasts by 47%. The Spanish producer Repsol saw a whopping 88% rise in third-quarter profits, with chief executive Josu Jon Imaz echoing the growing sentiment across all producers that they are readying themselves for a sub-$40 price environment.
The aim is to offer some re-balancing of the book – a much-welcomed move by investors that have mostly seen a loss on their investment since the crash in 2014. BP has already looked to remedy this with share buy-backs announced last week, a move showing the company is back in normality post the Macondo spill and the price crash according to CFO Brian Gilvary on an interview with Bloomberg. Similar moves are anticipated amongst the other majors in 2018, where like BP, there have been significant efforts of reducing net debt and increasing organic cash flow to cover dividends and operating costs.
Third-quarter results comparison between 2016 and 2017.
As the average industry break-even point solidifies within the $40-50 range, there is the increasing worry that the reduction in investment in new projects and capital cost cuts will hamper future growth. Despite this, however, some remain optimistic, with BP maintaining development of the deepwater Mad Dog Phase 2 project in the Gulf of Mexico. They managed to do this by cutting development costs by over 50%, through improved efficiencies and technology.
Supporting this sentiment is the recently concluded deal between Chrysoar, which purchased 10 mature North-Sea assets from Shell worth $3.18bn. Chrysoar’s chief executive Phil Kirk said he is “more than cautiously optimistic” about the North Sea and that mature basins have value to be extracted if done so carefully. At a time when companies are solidifying their asset positioning in the market, perhaps this bodes well for deep-water developments such as those in offshore Brazil and the Gulf of Mexico.
Like Chrysoar’s chief executive, the industry will hope to ride this oil bull with cautious optimism. Indeed, Big Oil will keep a keen eye on the U.S shale output as well as the OPEC meeting later this month, in hopes of further price increases, knowing that they are, at the very least, ready for the new ‘lower for longer’ environment.
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