The impact of plummeting crude oil prices on company finances

Crude awakening

What has caused the sudden fall in oil price? What effect will this have on the industry? Who will be the winners and who will be the losers? Our recent article provides a view of the impact the plummeting crude oil price will have on company finances.

The collapse of crude oil prices in the second half of 2014 caught many by surprise. The price of Brent crude fell more than 50 per cent from $115 per barrel (bbl) in June to below $50/bbl by early January in 2015 and shows no sign of reaching the bottom just yet. For four years up to June 2014 oil prices had remained consistently above the $100/bbl mark, which the Saudi oil minister, Ali Al-Naimi, viewed as the optimum price to balance the market between crude oil price producers and consumers.

The last fall of this magnitude was during the financial crisis: in July 2008 prices were approaching $150/bbl, but had plummeted to below $50/bbl by the end of the year. This dramatic price collapse was in response to severe recession in many countries. However, the fall proved to be temporary and oil prices were back up above $100/bbl by early 2011.                                                                               

The causes of the current prices collapse are not as dramatic. There has been no major world economic shock. Indeed the world economy is growing, although the recovery is not as rapid or as widespread as many have hoped.                                          

So why have oil prices more than halved? And what impact will these have on company finances in 2015? After years of relative stability, giving rise to confidence and investment in the oil and gas sector, major uncertainty is now being reflected in company balance sheets.

Why has this happened? Because supply growth…

While growth in global demand has been subdued in recent years, supply – mainly from non-OPEC producing countries – has increased leading to a surplus of oil in the market. In a November 2014 analysis, Citibank estimated that supply was exceeding demand by 700,000 barrels per day (bpd). This resulted in a build-up of oil inventories. For example, crude oil production in the United States has increased significantly in recent years: the country produced nine million bpd in 2014 compared with five million bpd in 2008. This has been possible because years of historically high and stable crude oil prices made shale oil projects – mainly in North Dakota and Texas – economically viable.

The mission of OPEC, as stated in its charter, is “the stabilisation of prices in international oil markets”. In the past, when oil prices were falling, OPEC would usually intervene in the market by cutting output to support prices. However, at its last meeting in November OPEC responded to the current surge in supply by maintaining production levels. At the time of the meeting the oil price was just over $70/bbl. In the three weeks following the Vienna meeting prices fell by a further $10/bbl and triggered a near ten per cent sell-off of crude inventories in a single day.

Many OPEC countries in the Middle East have taken advantage of the low costs of onshore oil production. The average cost of extracting oil from onshore fields in the Middle East is $27/bbl, less than half the cost of extracting North American shale ($65/bbl).

While the move to maintain current levels of production may sustain OPEC’s market share, it will increase pressure on high-cost producers, particularly in North America, who have increased production rapidly in the past decade. At present OPEC accounts for roughly one-third of total global oil production.

Total European crude oil consumption fell to 14.3 million bpd in 2013 from 15.3 million bpd in 2009, and 2014 levels may even be below 2013 figures. European economies are still grappling with weak growth and low inflation, making the threat of a third recession in six years a real possibility. Indeed, the European Central Bank announced that inflation in December was -0.2 per cent. The challenges are similar in Japan, where demand has dropped from five million bpd in 2007 to four million bpd in 2014.

Can shale survive in a lower-price environment?

While producers have been seeing their revenues decrease and debt levels swell since June 2014, share prices of US shale producers have been steadily falling.  This makes the short-term outlook for many shale oil projects very challenging, and the prospect of bankruptcy for low-margin producers is quickly becoming a reality.

The sector is facing serious funding difficulties that could have an almost immediate impact on production. The US shale sector’s main source of funding is debt. Most producers invest more cash than they earn and make up the difference by issuing bonds. According to The Economist, cumulative debt in the US shale industry is climbing and stood at $260 billion in December, and more than double the 2009 level. Debt to gross cash flow has doubled since the beginning of 2011. This means that the growth of debt is outpacing cash flow growth from investments in operations leading to shale producers becoming highly geared. Investors and debt markets are likely to become more reluctant to fund further investment, which could lead to a significant decrease in the number of US shale projects. As shale oil wells deplete more quickly than conventional wells – output can fall by 60-70 per cent in the first year – any slowdown in investment can translate into an almost immediate decline in production.

Yet the long-term future of shale oil seems more promising. Analysts believe that currently a median US shale project needs a crude price of $57bbl as opposed to $70bbl last summer. This is because larger players are able to produce oil more efficiently as they begin to achieve economies of scale. A shale oil well can also be drilled in as little as a week, at a cost as low as $1.5 million, which enables producers to react quickly to market conditions.

Winners and losers

The net effect of cheaper oil is expected to be positive on global growth. According to The Economist’s estimates, a $40/bbl price cut could shift some $1.3 trillion from producers to consumers through direct savings at the petrol pump, leaving households with more resources for discretionary spending in other parts of the economy, including goods and services.

However, most crude oil exporting countries are facing challenging times. Russia is heavily dependent on its oil revenues, with oil and gas accounting for 70 per cent of total export revenues. According to a Foreign Ministry adviser, Russia loses about $2 billion in revenue for every dollar fall in the oil price. The country’s state-owned Sberbank says oil prices need to stay above $104/bbl for the government budget to be balanced.

The economic sanctions imposed on Russia in the wake of the crisis in Ukraine have been exacerbated by the collapse of the oil price leading to capital flight of around $134 billion in 2014.

Most OPEC countries have little room to manoeuvre because of their reliance on oil revenues to balance national budgets. These include Iran (where oil prices of around $130/bbl are needed to balance the national budget), Venezuela, Iraq and Nigeria. Unlike the Gulf states (Kuwait, for example, requires a price in the mid-$50/bbl to balance its budget), they have no large foreign exchange reserves to fall back on to sustain state expenditure and the oil price collapse has been exacerbated by existing problems such as sanctions, political instability, security and corruption. Nigeria, for example, has been recently forced to raise interest rates and devalue its currency the naira.

By contrast, Saudi Arabia has $741 billion of currency reserves and posted a $15 billion surplus at the end of its last fiscal year. This means that it can run budget deficits for several years without causing major harm to the country’s finances.

The impact of falling oil prices on oil company finances

The most obvious impact of the oil price collapse on company accounts is the increased risk of impairment of assets. Lower oil price forecasts mean that producers should expect lower future profits from an asset. Subsequently, this reduces the present value of the asset, and if the value currently carried on balance sheets cannot be recovered in full, this results in write-off. There may also be a knock-on effect on related deferred tax and holding company investment balances.

Rapidly changing oil prices make it difficult to judge the present value of assets for investment decisions on capital allocation, an acquisition or for accounting impairment purposes. Companies often apply forward curves in their valuation models.

Lower operating cash inflows will inevitably lead to capital expenditure cuts and the potential write-off of exploration assets. In December, when crude oil was trading at $70/bbl, Goldman Sachs estimated that almost $1 trillion of spending on future oil projects was at risk.

In addition, reduced operating cash flows can ultimately result in business failure, so company boards will need to give greater consideration to judging whether the going concern basis of accounting, (i.e. whether the company is able to continue trading for the foreseeable future) is appropriate.

Companies may also find renegotiating debt challenging. At times of high oil prices, refinancing existing debt either through bank borrowings or issuing new bonds tends to be relatively straightforward. However, lower asset values and increased default risks mean that borrowers will face increasing challenges, including the need to pay higher interest rates or enhance security packages, if they are able to borrow in the first place. The price deck utilised by reserve base lenders (RBLs) may also be reduced significantly, leading to a reduction of RBL facilities and the acceleration of debt repayment schedules, putting even more strain on company balance sheets.

At times of high commodity price volatility, mergers and acquisitions activity can pick up. This might be a good time for those with available cash to acquire distressed junior players. However, this is rare and only tends to occur in extreme circumstances, as most vendors prefer to hold onto their investment until they get a better offer, if they are not being offered what they consider to be a fair value.

More companies may also return to hedge accounting, which was increasingly used in the wake of the financial crisis. With prices consistently above $100/bbl, most exploration and production companies were able to make profits without needing to hedge. However, many companies, especially large players, continued to pay for price hedging instruments as ‘insurance’ against a price fall. Lower prices may mean more producing companies, including smaller ones, could resort to ‘locking down’ their output with hedging instruments.

Finally, lower pricing leads to higher counterparty credit risk where counterparties are dependent on oil prices for cash flow. Where a company is part of a joint venture (JV), there could be an increased risk of JV partners being unable to fund their share of liabilities – including decommissioning costs – and this could result in other partners having to take on their share, putting increasing pressure on their own cash reserves.

Conclusion

The oil price collapse has given rise to a high level of uncertainty, which is being reflected in company balance sheets. After years of relative price stability, investor confidence in the oil and gas sector has plummeted, and for the moment there is little reason for confidence to return. The question most asked in the industry is whether this is ultimately a long-term downward structural adjustment in the price of oil or a short-term temporary correction. A number of recent analyst forecasts confidently point to a recovery back up to $80/bbl by the end of 2017. Whether they are right or wrong, the continuing uncertainty means that 2015 certainly looks like being a hugely challenging year for oil companies, oil producing countries and global policymakers.-Insight by

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