It is clear that upstream oil & gas will be a tough place for the next 12 months. The compound impacts of high-cost production coupled with low oil prices will squeeze profitability for all stakeholders.
It looks unlikely that oil prices will improve in the short term, as such. That means the industry has to focus on the one area it can influence – cost.
If you consider the macro position, we at Douglas-Westwood are of the view that the fundamentals are still intact and on the whole favourable.
Yes, there is a supply overhang with too many barrels being produced. With Opec not willing to cut production levels and non-Opec production being sustained, it could be as long as 18 months before the supply glut is absorbed relative to current demand levels.
We must remember, however, that global demand for oil has not declined over the past years and demand growth is set to continue over the course of 2015.
Markets will require an additional 1million barrels of oil to hit the 94million-plus barrels per day demand forecast by Q4 this year. However, we will see lower demand in the first two quarters in line with seasonal norms, which will continue to exert downward pressure on oil prices for the next six months at least.
While the upstream side of the oil industry will suffer in the lower price environment, the wider economy will benefit. Cheaper oil generally stimulates manufacturing, logistics and consumer lifestyle. In short, consumption is stimulated. That said, any such stimulus takes time to deliver, so benefits may not be truly tangible until 2016.
Will oil prices bounce from their current position? Yes! But the question is when. Our view is that an increase will not occur until late this year at best, and will still be sub $100 per barrel.
As a high cost region struggling with production decline and efficiency, thus lower profitability per barrel of oil produced, the situation in the North Sea and particularly the UKCS is perilous. This is an issue that will impact all stakeholders across government, oilfield services and E&P companies.
UK government is a key stakeholder in the UKCS and has a huge influence in the market, fiscally. It has to evolve legislation that reflects the current realities and economics of the province to maintain a positive investment climate.
But I fear that any changes to fiscal policy will not go far enough, if past history is any measure. As such it will be the industry that will need to react first.
Starting with the majors/super-majors we will see a reduction in activity and spending levels coupled with further rationalisation of their workforce globally. This will be over and above personnel cuts implemented in the latter part of 2014 as they strive to get significant cost inflation back under control.
Most of the IOCs were struggling to generate sufficient returns on capital at $100+ oil prices. With Brent now in the range $55-60, their focus will inevitably be rationalisation in high cost areas like the North Sea. That means budget cuts and job losses.
Shareholder pressure
Turning to independents, the future is even bleaker. Those that have pinned their futures on new developments will be hit hard as they effectively have all their eggs in one basket. Sadly, the basket is in an area with complexity, high costs and thus high risk from a profitability perspective.
It means they will likely come under shareholder pressure to reduce costs and bring production to market faster. Some may be forced into mergers designed to diversify asset portfolios, create efficiencies and to secure access to capital.
For exploration focused independents, life is set to get frustrating. Falling rig rates mean cheaper exploration. The frustration, however, will be that investors will likely not see things the same way. They tend to be short-term focused or don’t on the whole understand theupstream sector.
As for service companies, it is clear that they are going to come under price pressure. A blanket cut of 10-15% off current pricing will be sought across the supply chain from the E&P companies as a minimum. Service companies commanding high margins will be the natural first target.
With drilling accounting for 30-40% of development costs and operating at some of the highest margins in the industry it’s likely this area will be a focus for cost reduction. A large component of well cost is rig rental, the rates of which are determined by supply and demand. As demand decreases rig rates will follow.
Rig market issues are compounded further by the number of new-builds due for completion this year and next. The impact of their collective arrival will be softened to some extent as older units are retired and broken up. Yes, this really is happening and is something we haven’t really seen in previous cycles.
As rig rates and the cost of associated drilling support services and consumable products drop, other related services will follow such as logistics, port services, marine vessels, anchor and container rentals . . . the list goes on.
Cost reductions of as much as 20% will be sought in the UK this year, with further cuts possible if the downturn becomes more prolonged.
In partial contrast, subsea’s outlook is more favourable. Many of the firms in the UK have a higher international leverage to their businesses and will be better protected from North Sea cuts. This said, the number of new entrants to the market over the last cycle, particularly construction vessel players, will make it very hard for some of the smaller, more leveraged providers to survive a downturn and reductions in vessel utilisation.
And finally to engineering, where the model has to change. The “contractor” model where masses of self-employed engineers provide support to projects creates huge inefficiency and is expensive.
Contractors are unwittingly motivated to be inefficient and take time, they are fluid and move from one project to another creating wage inflation and a lack of continuity, in addition to having little commitment to organisational performance.
Efficiency
The market quite simply can’t operate on this model for much longer. Staff ratios will have to increase, plus people will need to work harder, be given more responsibility and ownership and be motivated by efficiency.
OK, where’s the good news?
Personally, I think the whole adjustment in the UK and global upstream sector is the good news story. The industry has become flabby on the back of high oil prices and “throwing money” at problems as opposed to addressing more fundamental issues.
The next 12 to 24 months will force E&P and service companies to re-examine their processes and operations. It will be hard and perhaps terminal for some in the short-term; but the industry will emerge leaner, fitter and ready to grasp the opportunities that the next upswing will inevitably bring.
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