Senior Partner & Managing Director, Vice Chairman, Energy Practice
Related Expertise:Energy & Environment
The past six months have witnessed a dramatic drop in oil prices, which have fallen to levels not seen since the 2008–2009 financial crisis. Indeed, the price of crude has been roughly halved, piercing the $50 per barrel threshold in early January 2015. The plunge in prices has exacted a sharp toll on many oil producers, especially those that are smaller and highly leveraged, and has threatened the viability of many large offshore and heavy-oil projects. Furthermore, it has jeopardized the survival of many key energy-service companies and created a sizable gap in the budgets of governments that rely heavily on oil revenues.
It remains to be seen whether—and, if so, for how long—the current low-price environment and the resulting financial “endurance challenge” it poses for producers will persist. (See Exhibit 1.) Indeed, even assuming a degree of cost deflation, breakeven costs of marginal projects suggest that over the longer term, companies would be wise to consider a scenario of higher oil prices, one in which price levels are closer to those that prevailed through mid-2014.
For the near to medium term, however, we see little reason to expect a significant, sustained recovery in oil prices. U.S.-produced shale oil will continue to exert upward pressure on global supply. By drastically reducing oil imports into the U.S. and forcing producers to look elsewhere to compensate, U.S. shale oil has also created a war for market share in Asia, one that will likely lead to sustained pricing pressure in the region. In Asian economies, meanwhile, weaker-than-expected demand growth—a major factor behind the plunge in oil prices—persists, and recovery may take some time.
Furthermore, OPEC—which has less influence on the market today than in the past (it delivered 32 percent of global oil volumes in 2014 compared with 40 percent in 2005 and averaged 47 percent in the 1970s) but remains a force to be reckoned with—seems disinclined to play its historical market-balancing role by, in this case, curtailing supply. While the stress of this stance is clearly weighing on certain OPEC member nations, such as Venezuela and Iran, Saudi Arabia is the most critical player, as it holds 72 percent of OPEC’s current spare production capacity. And the country seems quite content to let the market self-correct, believing that a period of stress for marginal producers and high-cost projects will lead to a more stable and sustainable pricing environment over the longer term.
In short, oil prices will likely remain relatively low and unpredictable for a period of time. What does this mean for the oil and gas industry and businesses and governments broadly? What tactics and strategies does it call for?
Historically, falling oil prices have translated into financial stress for producers but provided a general boost to the global economy because the effects of any reduction in producers’ investments are more than offset by an increase in consumer spending. This is largely what is happening today, but the story is more nuanced.
The recent fall in oil prices has been driven not just by supply factors but also by demand ones. And the demand situation remains fluid. Many key economies remain weak, and this weakness is dampening any stimulus that low oil prices might provide. This is exacerbated by the current strength of the U.S. dollar. Oil prices may have fallen by more than 50 percent, but for many non-U.S. consumers, the local cost of oil has fallen by nowhere near that amount.
Also, low interest rates in many countries limit governments’ scope for stimulating economic growth through further cuts and, hence, increasing energy demand. Finally, many oil projects today are of such scale and global scope that their cancellation affects the economies not only of the producing countries but also those of many others that provide the goods, services, and expertise necessary to deliver those projects. Indeed, it is estimated that $50 oil has placed $150 billion of upstream investments at risk.
Companies are exposed to these dynamics and the resulting changes in oil prices to different degrees. We identify three specific segments: producers (including both oil and gas production companies and governments that derive significant income from oil either directly through their national oil companies or through taxation); energy service companies (including service, equipment, engineering, and construction companies, along with support service companies, such as those that provide logistics and camp services); and consuming and processing industries (such as refiners, airlines, shipping companies, and manufacturing and heavy-industrial-process businesses).
Producers. Obviously, producer organizations face a period of sharply lower revenues from their oil and oil-linked assets, especially as the companies’ hedged positions unwind. Previously established financial targets for 2015 and the future are unlikely to remain valid; the degree to which actual returns differ from targets will vary widely by company and will be driven by the fiscal terms, hydrocarbon mix, and hedging strategies of the companies’ portfolios. Financing, meanwhile, is increasingly less available or more costly, particularly for smaller and exploration-led businesses.
Regarding new investments, the economic screening criteria that companies had been using to vet their current projects are no longer valid, so many planned projects are no longer viable. And, structurally, investment is nearly impossible in some high-cost, high-complexity, or high-tax areas that currently make up important parts of some portfolios. In a scenario in which Brent crude is priced at $50, for instance, Henry Hub liquefied natural gas (LNG) priced at $3 per million British thermal units is $1 to $2 more costly than Middle Eastern LNG for Asian deliveries.
In terms of external factors, market demand for assets, services, and talent has slackened. Simultaneously, many competitors and suppliers are facing financial stress or even extinction. Highly leveraged producers—particularly U.S. independents, small-capitalization businesses, and private-equity-backed new entrants with heavy debt financing—are expected to suffer liquidity and financing crises.
Energy Service Companies. For some time—since early 2014—many of these companies have faced severe cost pressure and demands for contract renegotiation from operators. They have also faced postponement and demands for reengineering of some large, high-cost projects. The pressure has been particularly acute for offshore-oriented service companies, which have been affected by a wave of new construction of offshore rigs and service vessels (for example, pipe-laying vessels) that has led to looming overcapacity in some markets. Recent declines in prices have not only intensified this pressure but have also extended its scope into areas—such as onshore work for drilling and well service providers—that were previously havens of healthy growth.
As with producers, service companies’ financial targets for 2015 and the future are unlikely to be valid, given the current environment, and companies will need to review their investment plans carefully. Some companies will also find that their portfolio of assets and service offerings is not well matched to today’s market demand. In particular, the market’s appetite for high-tech, high-cost, discretionary services is likely to remain low unless a company’s offering is accompanied by clear proof of value.
Amid this weakness, however, strategic M&A activity—as demonstrated by the November 2014 Halliburton–Baker Hughes deal—is under way and will intensify. And private-equity firms, which have long been enthusiastic about the sector but have sometimes been deterred by what they consider its unrealistic valuations, are becoming increasingly inquisitive and active.
Consuming and Processing Industries. Clearly, the first-order effect of falling oil prices for these companies is lower input costs, with the degree of reduction dependent on both foreign-exchange effects and the companies’ degree of exposure to oil prices. Transportation fuel costs have already fallen sharply in concert with the drop in crude prices: prices for jet fuel, for instance, which represents 26 percent of airlines’ costs, fell by 52 percent between August 2014 and mid-January 2015. Changes in power costs due to falling oil prices, meanwhile, can vary considerably by market and region, and, in many markets, gasoline prices are so inflated by taxation that the impact of lower oil prices for consumers is considerably dampened. But the effects can still be significant: for a 300,000 barrel-per-day refinery that burns fuel oil for internal consumption, for example, a 50 percent drop in oil prices can translate into an annual cost benefit of $200 million.
Many companies are also facing price reductions that are the result of competition fostered by the lower costs: airline fares, for example, are expected to fall by more than 5 percent in 2015. The effects of lower oil prices on demand are highly variable and sector dependent: demand in the transportation and logistics sectors, for instance, tends to be fairly inelastic.
For hybrid companies—for example, a utility that has an exploration and production division (such as Centrica) or companies that have both upstream and service exposure (such as SapuraKencana Petroleum or Petrofac)—the impact of lower oil prices can vary: companies face complex and overlapping effects specific to their portfolios.
In the worst case, a company can be exposed to mutually reinforcing negative effects that are more severe than those faced by single-segment companies. But for others—such as integrated oil and gas companies that have exposure in refining and petrochemicals—the negative effects related to their upstream activities can be dampened by benefits to other parts of the business.
In crafting responses to this environment, companies should keep in mind three lessons from past oil cycles:
First, sharp and protracted swings in oil prices, such as the one we are experiencing now, do not last forever. Indeed, the current down cycle is already the longest peak-to-trough progression of any of the sustained oil-price declines since the 1980s. (See Exhibit 2.)
Second, the opportunities and threats typically emerge early. Markets are quick to price in weakness, and valuations can be hit hard. This is evident today in the offshore seismic sector, for example, in which some valuations have fallen by more than 50 percent.
Third, a fast response is critical, whether it be positioning the company for survival, communicating to investors, or capturing emerging opportunities.
Given those lessons, we see six critical imperatives for companies across the three segments.
Precisely how these should be applied to individual companies varies by segment. (See Exhibit 3.)
Producers. The most important actions for producers are to fully quantify their exposure to oil prices under different scenarios for the months ahead and determine their organizations’ resilience.
Many producers were already engaged in cost and efficiency improvement efforts in early 2014—when oil prices were near $100—in an effort to stem declining returns on capital. Today’s price environment has made those efforts increasingly urgent.
Producers should quickly review marginal and discretionary investments and delay or shelve them if necessary. They should also ensure that efforts aimed at improving their performance on the operational, supply chain, and cost fronts are geared toward delivering concrete results: leading companies have been pursuing this approach aggressively and expect to achieve operating-expense reductions of $1 to $3 per barrel in the coming year. (See “Killing the Complexity Monster in E&P: Eight Critical Actions for Upstream Oil and Gas Companies,” BCG article, January 2015.)
As a defensive measure, each producer should monitor key suppliers’ health and risk of failure and determine the potential impact of supplier distress on the company’s ongoing projects with regard to quality, safety, and asset availability. This is
particularly vital for relationships with suppliers that provide large, hard-to-replace assets, such as installation vessels, without which major projects can suffer critical bottlenecks.
In terms of strategy, producers should critically review their asset portfolios. Those with strong cash flows should scan for acquisition opportunities; those with weaker positions should explore opportunities to divest and refocus.
Regarding staff, producers can view the current low-oil-price environment as a helpful catalyst for rationalization and reorganization aimed at improved efficiency. But they must take a long-term view and make sure that they retain their best talent.
Producing governments must ensure that their fiscal terms fit the current price environment, offering reasonable returns on production and encouraging ongoing exploration activity. For governments, achieving this will likely demand greater flexibility, as well as allowances for less attractive assets and exploration prospects. For some producing countries, today’s oil prices might serve as a catalyst for more fundamental reform. For example, Mexico’s government recently opened its oil industry to foreign companies. (See The Promise of Mexico’s Energy Reforms, BCG Focus, April 2014.)
Energy Service Companies. Like producers, service companies should thoroughly quantify—under various scenarios—their exposure to oil prices as well as their resilience to price changes. Many service companies are conducting detailed reviews of their current project backlog (to identify postponement risks) and pipeline projections and are revising targets and investment plans accordingly. In today’s environment, service companies must also ensure that their sales and business-development teams are aggressively focused on securing utilization of the companies’ heavy assets while simultaneously managing the risks of taking on projects in a highly competitive market.
Service companies must also work to create efficiencies within their supply chains. In concert, they should actively approach clients with proposals for collaborative cost savings: in many cases, service companies are well placed to show operators how their processes, standards, and behaviors add cost or time to activities. Furthermore, service companies should intensify their efforts to improve internal cost efficiency and productivity, learning from sectors as different as automotive and retail that have long faced severe performance pressure.
Strategically, service companies should take advantage of the current environment to quickly retire or rationalize costly, aging assets and infrastructure, including vessels, bases, and rental fleets. Service companies that do so will have a stronger, more efficient base from which to recover. Such rationalization can also deliver related head-count and support-cost benefits. Still, service companies must take care not to lose a generation of critical talent in the process—a problem experienced by service companies in past oil-price cycles.
Where they have latitude, service companies should work to ensure that their offering is relevant to the current environment and tied to more secure spending. Service companies can emphasize nondiscretionary, operating-expense-driven services, for example, rather than those attached to complex, major projects.
Finally, service companies, like producers, can treat the current low-oil-price environment as a catalyst for reorganization or acquisition. For oilfield service companies, in particular, this can be a highly effective strategy. Indeed, cyclical acquisition has long been at the bedrock of the industry’s structural evolution, and new opportunities for acquisition are already emerging. Service companies should not only be scanning and approaching potential targets, they should also be preparing efficient processes that will facilitate the rapid execution of deals as well as the integration of acquired companies.
Consuming and Processing Industries. Consuming and processing industries may be benefiting from the current level of oil prices, but they still need to act. It is critically important that companies for which energy is a major cost establish an explicit board-level energy strategy that defines their exposure to energy prices. And they should design a plan for managing that strategy. This lever is generally underused, in our view, and is particularly valuable in the current market.
Companies in consuming and processing industries must also lock in any cost advantage that has emerged as a result of lower oil prices and work to compete effectively on the basis of the pricing made possible by this advantage. These companies should also map out scenarios that detail the potential effects of low oil prices on customer demand for their products. The resulting demand profiles, defined by cohort, may prompt consuming and processing industries to rethink and possibly broaden their target client base.
Lower oil prices present both challenges and opportunities for companies across all three segments. Capturing the opportunities demands a structured response, the attention of senior management, and rapid action. This is a tall order but vital, as the steps that companies take in today’s exceptional market will dictate their competitive position in the next phase of the cycle.