Introduction

In January 2015 the price of a barrel of Brent crude slipped below $50 for the first time since May 2009. A surprise surge in global production and weaker than anticipated global demand upset what had been a fairly stable market with oil prices trading around the $100 - $120 per barrel range for the last three years, despite a number of significant geopolitical events affecting petroleum producing countries.

The industry is awash with speculation about the forward price curve for oil: will the fall in oil prices be short lived or is this the beginning of a new world order of materially lower oil prices? While speculating as to why the market is as it is - or where it is going - is a natural reaction, prudent oil companies would be wise to take stock of prevailing market conditions and to realign their business strategies to address the new challenges and risks posed by lower oil prices.

Organise Rather Than Agonise

In order to effectively manage the risks of lower oil prices, oil companies need to determine where costs can be reduced and where savings can be made. Carrying out a detailed review of the operational and financial aspects of their business and determining where the business can be rationalised and optimised should be a priority for any oil company operating in a cheap oil market.

Oil companies carrying out a review of their business and operations need to focus on controlling expenditure and operating costs as well as implementing focussed risk management across their business and assets. An analysis of the relevant underlying concession and operating agreements should focus on voting powers and rights to veto or cancel capex and/or reduce opex. Reviewing default provisions will provide guidance relating to costs associated with default or available remedies for non-defaulting partners. As service providers come under increasing pressure to offer more competitive terms and prices, there should be scope for project operators to renegotiate or retender service contracts in order to secure cost reductions. If contracts for the sale, transportation or processing of petroleum have been entered into, operators should review rights of interruption. A review of material contracts should give particular attention to exit provisions and force majeure conditions which could allow parties to exit or suspend unprofitable operations. An overall cost/benefit analysis of maintaining contracts versus termination should be carried out and, where appropriate, implemented to reduce costs.

Projects need to be run efficiently, now more so than ever before, so oil companies need to be proactive in making interventions if projects are unlikely to deliver an IRR that the project sponsors had planned for. Where projects are facing cost overruns, partners should agree to either re-scope, defer expenditure or (if the contracts allow) stop or delay production until the market has recalibrated itself. Lower costs need to be achieved so operations which are too expensive may need to be aborted or remodelled. Delaying final investment decisions on development projects or shutting in production on producing assets may have the benefit of reducing costs without reducing ownership interests in assets which could be profitable in the future when oil prices increase or other production costs decline.

Time and resources spent optimising capital structures and restructuring balance sheets will be time well spent. As the price of oil declines, oil companies may find that liquidity of capital becomes more restrictive and debt financing becomes increasingly more expensive as lower oil prices alter the industry’s capital risk profile. In order to reduce the need to take on increasingly burdensome financing, oil companies should seek to optimise their capital structure and overall financial position in other ways including: restructuring corporate and tax models, divesting assets and reviewing the company’s dividend policy. The industry is contracting and reducing shareholder dividends in the short term may be necessary for the The fall of oil prices happened quicker than most oil companies expected, and many are waiting to see the stabilisation of oil prices before reworking their corporate strategies and economic models. This reactionary approach could be costly in the long term, as it is those who react swiftly who should be better positioned to decrease exposure and to mitigate the negative impacts of low oil prices.

Divest Carefully Not Recklessly

A review of operational and financial aspects of the business (in addition to being a cost-reducing exercise) should be a key component in formulating a clear strategy for an oil company’s divestment program. A divestment does not need to be structured as a simple cash sale: relinquishments, swaps, farm-outs or mixed consideration (cash/shares) could be more appropriate, given the risk profile and strategic objectives of the company.

All companies will be seeking to remove underperforming businesses and assets with lower yields to balance their portfolios; sellers, however, need to be mindful of the fact that prospective purchasers will not be interested in low yield assets. In order to attract investors, sellers should consider combining the sale of lower yielding assets as a package together with exploration and/or development opportunities, farm-in options or the offer of other strategic collaborations.

The sticking point in early negotiations is likely to be price allocation; oil companies across the industry will be waiting anxiously to see how early divestments are valued in order to benchmark their own portfolio. Oil companies looking to divest poorly performing assets should assess the costs implications of retaining high cost assets against the cost of a discounted divestment to facilitate a quick sale. Assets with high costs will deplete cash reserves which could otherwise be better utilized picking up healthier assets in growth markets or maintaining the balance sheet and financial ratings of the company.

At the deal structuring and execution stage, sellers should carefully consider the scope of price review clauses, warranties, MAC clauses and other hardship clauses, as these can provide additional protections in a collapsing market. Sellers should also take into account the financial capacity of prospective purchasers and should consider if parent company guarantees, bank guarantees or alternative collateral support measures are necessary to secure the deal.

This is a turbulent time for the industry but it will be the oil companies who act decisively in managing their cost base and capital structure – by building in resilience where necessary and rationalising where appropriate – that will be best positioned to endure lower oil prices and to capitalise on any opportunities which may become available.

Carpe Diem

The founder of Standard Oil and father of the modern oil industry, John D. Rockefeller, once said that “with every crisis comes a new opportunity”. Rockefeller was no stranger to turbulent oil prices; he presided over Standard Oil during a period where oil prices fluctuated unpredictably. Rockefeller recognised that low oil prices provided opportunities to pick up assets with good reserves and development potential cheaply as competitors hurried to monetise assets which had become economically unviable. Rockefeller kept Standard Oil well-funded and was able to leverage these reserves when the market contracted, picking up discounted assets which could be profitable when oil prices picked up. We would do well to remember how Standard Oil rose to dominance pursuing a strategy of consolidation. 

Citigroup recently collated the breakeven price of major oil projects around the world highlighting that most projects require oil prices to exceed, some materially, $50 per barrel in order to break even.1 If oil prices continue to fall or if they stabilise at levels around the $50 mark, many oil companies will seek to mitigate their financial risk by divesting assets that are too expensive to develop or run given the shape of the proposed development and/or the IRR requirements of the project developers. Distressed M&A activity is therefore likely to allow well-funded companies to acquire assets with good reserves and production potential on favourable terms.

The fact is, it is a buyers’ market and the best deals are to be had while oil prices are falling. Prospective buyers should move fast in order
to get the price and key terms agreed and contractually bound while sellers are eager to sell as bargaining position will begin to erode when prices start to increase. Buyers should focus on getting comprehensive due diligence done quickly and effectively and get deals closed quickly. Assets with low capex or opex and long-lead work obligations may make good acquisition targets as they keep the balance sheet looking healthy and the delay in outlay will help project owners capture the benefits of higher oil prices and/or cheaper production costs.

Not all players will have the requisite balance sheet or financing in place to embark on acquisitions even where there are deals to be had. If financing is not available, it is better to let a deal go rather than risk stressing the balance sheet in these precarious times. The primary aim for any oil company should be streamlining the business and mitigating potential losses until oil prices pick up; capitalising on market opportunities should be a secondary aim and a collateral benefit.

Concluding Remarks

It is unknown if the fall in price will be a “V” with a rapid return to high prices or a “U” with sluggish recovery, but 2015 is likely to be a tough year and hard decisions will need to be made. Getting into shape is never easy but is essential for survival when there is less to go round. Everyone in the industry will need to adapt.

The years of high prices allowed the market to soak up additional costs and project pricing has soared since the early 2000s. Getting control
of costs and monetising poorly performing assets should be at the top of the agenda for oil companies. Failure to manage the risks of low
oil prices will cost parties dearly; projects which were modelled on $100 barrel oil need to be remodelled or rescheduled to avoid soaring costs and plummeting profits.

Every oil company recalibrating its business model in line with the new economic landscape should remember that the need to react quickly should be tempered with the need to react prudently. Before embarking on significant divestments or acquisitions, oil companies should carry out a portfolio-wide review of material contracts and formulate a clear strategy with profit optimisation and cost control at the centre. The oil company should determine where savings can be made, where assets can be monetised, if there are alternate strategies to divestment and if there is scope for making strategic acquisitions.

Oil price volatility is not a new phenomenon, and if history is anything to go by, we can assume that oil prices will inevitably rise again; after all, one needs to bear in mind that oil is a finite resource. When oil prices rise, it will be those who took tough and timely decisions to mitigate the effects of cheap oil who will ultimately have the optimum balance sheet, portfolio composition and market positioning to weather the storm and to maximise gains when prices recover.

_{1. https://ir.citi.com/gpV66Qk64p1uNrDu8zrJ%2BoggS0GEiCbDfSD5C3XzQb1aJyWX i4psLw%3D%3D.}