Counting the cost as oil prices plummet

By Robert Outram, Editor of The CA magazine

5 February 2015

As Brent Crude dips below $50 a barrel, Robert Outram reports on the future of an industry in shock and what business and government can do to help. 

In just a few short months, the UK oil sector has gone from reliable cash cow to an industry apparently in crisis. The reason, of course, is the slide in the global oil price.

At the time of writing, the price of Brent Crude had just slipped below $50, something that would have seemed almost unthinkable earlier last year, and both the Westminster and Scottish governments announced the creation of task forces to address the future of the industry.

How did this happen so quickly and what are the implications in the long and short term?

What has driven the oil price down?

The simple answer is "supply and demand". Oil prices at a sustained high level over the past few years have encouraged investment in new production across the world. This has included the use of new technology to exploit previously unavailable deposits, such as "fracking" in the US and Canada's oil sands.

More recently, economic growth in many parts of the world has slowed or stalled. The Eurozone has seen very low growth and China has just reported annual growth of 7.4 per cent, a decline from the double-digit percentages it once enjoyed.

The International Monetary Fund (IMF) has lowered its forecast for global economic growth for this year and next. It now expects growth of 3.5 per cent this year, compared with the previous estimate of 3.8 per cent, which it made in October.

Frances Hudson, global thematic strategist with Standard Life, comments: "Historically, Saudi Arabia [as the largest producer] was able to control the oil price but their geopolitical position is less strong... and the incentive for oil-producing nations to co-operate is not strong."

Some have seen a political motivation in the Saudis' refusal to cut production, with Russia and Iran both suffering as a result of the lower oil price, but it may simply be that Saudi Arabia no longer has the influence it once had to move the price unilaterally. Also, as a low-cost producer, Saudi Arabia has less to lose from cheap oil than high-cost producers such as the US fracking sector.

Hudson also points out that commodity prices tend to fall when the dollar is strong, as it has been in recent months. Commodities like iron ore and copper have also plummeted in value. She also says that, while the market had been aware of supply factors, there had been "unrealistic expectations as regards the demand side".

Iain Armstrong, oil industry analyst with Brewin Dolphin, says: "It's the speed at which this has taken place that has surprised the market." He adds that other factors have played their part, such as an unexpected increase in Libya's output and a fall in China's demand for diesel.

Iain argues that reducing output by closing down assets is not necessarily a viable short-term option: "Oil sands production in Canada has not reduced because the cost of shutting down a facility and starting it again later is too great."

Who are the winners and losers?

Clearly, consumers stand to benefit from cheap oil. Independent economic forecaster the EY Item Club suggests that Britain's economy will experience the fastest growth in a decade in 2015, with GDP growth of 2.9 per cent and real household incomes rising by just under 3.7 per cent.

Standard Life's Frances Hudson says: "If it's only a transfer of wealth from producers to consumers it will not benefit the global economy overall, but it could provide a boost if consumers are more likely to spend in the short term than producers."

She adds that, as oil is priced in dollars, for some countries the rise in the value in the dollar could partially offset the benefit of cheaper energy.

For oil-producing countries like the UK, $50 oil clearly creates a very difficult environment. BP recently announced 300 job losses for employees and contractors in the North Sea and more bad news in the industry is expected.

What should the industry do now?

Ken McHattie CA, chairman of Aurora Petroleum and vice-president of ICAS, says: "The industry needs to avoid knee-jerk reactions. Very few people predicted such a deep fall in the oil price and very few companies will have been prepared... the industry will have to adapt as best it can because the impact of the current price level will be different dependent upon where any business is located in the industry life cycle."

Ken added that the downturn in the oil price would certainly affect both investment and recruitment, and that its impact on exploration was a major concern.

Duncan MacAskill CA, senior partner with KPMG in Aberdeen, comments: "The exercise of reviewing costs against forecasts should now be towards the top of every board agenda. The reality is many businesses in the sector, whether they are oilfield operators, explorers or service providers, will have been reviewing their costs, expenditures and forecasts for some time as cost inflation beset the industry in recent years. Managing cash and costs is now very much part of the day job for all levels in the sector."

"There is a need for balance in the assessment of what's happening", says Derek Henderson CA, senior partner with Deloitte in Aberdeen. "The industry has historically managed volatility in the oil price; nonetheless businesses need to take a serious look at how they are set up and at their costs.

"It's not just about head count and contractor rates. It's also the industry's whole business model, including collaboration, standardisation measures and so on that some other jurisdictions have already put in place."

Derek points to the Gulf of Mexico and Norway as oil-producing regions the UK could learn from. He adds that his firm's poll of senior figures in the industry indicated support for the reforms set out by Sir Ian Wood in his recent report, which included greater collaboration between operators, and a new regulatory body for the North Sea.

"The question is," Henderson says, "to what extent is the industry ready to change its behaviours and its mindset?"

What can the government do?

Malcolm Webb, head of industry body Oil & Gas UK, told reporters ahead of a crisis meeting with UK energy secretary Ed Davey: "Some companies are paying 80 per cent as the highest tax rate on fields in the North Sea. We would like to see 30 per cent as the top tax rate and our industry treated the same as any other."

Jann Brown CA, CFO and founder of Magna Energy, former FD and managing director of Cairn Energy, and president of ICAS, says the UK Government needs to review the way the industry is taxed, given the circumstances.

She said: "Every industry has to stand or fall on its own profitability and the oil industry is no different. Of course, the fiscal regime currently has a higher marginal rate of tax for profitable projects than for other industries, and this should be considered, alongside fiscal incentives for projects which are now marginal at current prices and which will create jobs in the UK."

Jann added: "More broadly, governments should be thinking about energy security."

Deloitte's Derek Henderson says: "We still have a low level of exploration activity and unless we sort that out sooner rather than later, that will make for a gap in future production. Developing assets is a key issue, from early stage through to production. Targeted tax allowances could help make that happen. The headline tax rate has also been a deterrent."

As The CA went to press, the UK government had just announced proposals for a new investment allowance to replace most of the existing field allowances. The new measure, based on capital expenditure, is intended to be simpler and more attractive to developers.

Is there a silver lining?

For professional advisers there may be a bright side, if the pressures on producers and services businesses lead to a rash of M&A activity with the strong absorbing the weak.

Drew Stevenson CA, PwC's UK energy deals leader, comments: "Oil prices remaining at the current level for a sustained period will light the touchpaper for mergers and acquisitions in 2015. As the UK industry positions itself for a more uncertain future, we expect to see deal activity levels pick up throughout the year ahead."

Among those likely to be on the trail of acquisitions or mergers, Stevenson says, are energy specialist funds, national oil companies and sovereign wealth funds. He also expects to see activity in the form of paper-based deals aiming to achieve cost reductions and positive synergies through mergers.

KPMG's Duncan MacAskill agrees: "We are starting to see an increase in M&A activity as some businesses concentrate on core activities, and growth opportunities arise for others."

Standard Life's Hudson points out that the spot price for oil is, unusually, lower than the forward price, indicating that speculators expect the price to go up again later this year.

Peter Rose CA, finance director with international oil services group Hunting, is cautiously optimistic. He said: "I view this as a temporary blip which will bounce back once surplus capacity in the market is taken out through reduced E&P activities (including North American shale), the continued depletion of existing wells and any increases in consumption. How long this blip will last is unknown, but if I were to guess I would say six to nine months."

As Colin Welsh CA, chief executive officer with energy specialist investment bank Simmons & Company International, puts it: "The consensus of oil analysts is that the sharper the drop in price is, the bigger the bounce back will be... 2015 promises to be a period of great opportunity for those who believe that the positive prognosis for oil and gas in general, and oil services in particular, remains intact."

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