September 7, 2009

Taking a Chance on Oil: Thinking Beyond the Oil Market Downturn

With oil prices dropping consistently below a long-term level of at least $60 to $80 per barrel, oil ‎companies can gain competitive advantage by thinking long term.

The current recession and the nature of cash-starved financial markets provide an attractive ‎investment environment for energy companies with the willingness and cash to take a long-term ‎view. Recessions don’t last long when compared with the average length of energy investments; ‎therefore any forecast of the profitability of capital investment whose output will go on stream ‎perhaps seven to nine years from now must look beyond the short-term, found a new report by ‎Booz & Company.‎

Following years of high oil prices, many international oil companies (IOCs) and national oil ‎companies (NOCs) have amassed piles of cash, and are in an excellent position to take the long-‎term view. NOCs controlling reserves of cheap oil but lacking the technology and capabilities to ‎further their investment efforts should consider acquiring independents and weakened oil service ‎providers. “Meanwhile, independents in weak financial positions might decide to partner with ‎cash-rich IOCs or NOCs,” commented Georges Chehade, a partner at Booz & Company.‎

The Oil Price Roller Coaster

In July 2008, oil prices per barrel reached an all-time high of more than $147 and analysts ‎forecasted prices of over $200 by December 2008. But by December, the price of oil had dropped ‎almost 80 percent, to less than $34. Always difficult to forecast, energy prices have reached a ‎completely new level of unpredictability in the last few months. ‎

‎“Energy companies whose economics depend on future oil prices must make investment ‎decisions. In the long term, the average price of oil is a lot more stable and more predictable than ‎its daily spot price—this long-term average is what determines the profitability of energy ‎investments,” explained Chehade. The global liquidity shortage is leading financial markets to ‎underprice long-term value, presenting an opportunity for companies with cash to make these ‎investments now.

The Long View

In the current recession, oil prices are seriously depressed. The effects the downturn is causing ‎will last longer than the recession itself and the duration of typical economic recessions are short ‎when compared with upstream oil investment standards: The mean duration of all U.S. ‎recessions since 1854 is 17 months from peak to trough, and the average is just 10 months for ‎the 10 recessions since the end of World War II.‎

It takes at least seven to nine years for energy exploration efforts to bear fruit in the form of oil or ‎gas coming on stream. What really matters for these investments is the price at which future oil or ‎gas will be sold. Energy prices tend to revert over time to some long-term mean and this more ‎stable and predictable than the day-to-day spot price. ‎

A realistic picture of long-term petroleum price relies on long-term projections of supply and ‎demand. Long-term demand is almost as predictable as short-term prices are erratic. Global oil ‎and gas consumption rates have displayed a constant upward trend for more than 30 years, and ‎the trend is expected to continue at roughly the same pace in the future. This leads to an oil ‎demand forecast of about 100 million barrels per day by 2020, up from today’s 85 million or so, ‎plus 65 million barrels of oil equivalent (BOE) per day of natural gas, up from close to 55 million ‎today. To meet this demand, more than half of the total production by 2020 will need to come ‎from new investments. ‎

Today there are more than 1.2 trillion barrels of proven oil reserves in the world (including about ‎‎800 billion in cheap reserves in the Middle East and North Africa). Yet the long-term supply curve ‎is a lot tighter than these figures suggest, because only so much oil (or gas) per day can be ‎pumped. “Newer, more expensive hydrocarbon sources will have an increasingly large role to ‎play—given the forecast demand and available sources, the long-term central equilibrium price for ‎the next 10 to 15 years will probably be around $60 to $80 a barrel,” Chehade stated.‎

There is a very high probability of another big price spike within the next decade. Today, in ‎addition to low oil prices, companies are facing a global liquidity shortage. It is likely that many ‎companies will reduce their exploration and production investments, even though more ‎investment is required to meet future demand; which will likely prompt a massive price increase ‎and reward those who can keep their heads cool enough to take the long-term view.‎

The Post-bubble Opportunity

The oil price collapse is having a cooling effect on many companies’ investment plans. Recently, ‎most oil companies gradually increased the base forecast price on which they estimated the ‎profitability of their investments—a number of the projects initiated under these assumptions are ‎now being questioned and even abandoned.‎

The picture is particularly gloomy for many upstream oil independents: “With rapidly falling market ‎value of their assets and the levels of financial leverage they took on during the recent boom, ‎many may be forced to downsize, be acquired, or simply go out of business,” said Chehade.‎

A few top players are taking a longer view, particularly in their upstream investments. Several ‎leading IOCs and NOCs, including Chevron, Shell, Total, and Saudi Aramco, have stated their ‎intention to maintain their current levels of upstream investment, and some have already started ‎to take the offensive. ‎

For companies with cash, willing to invest, they will encounter a much more favorable cost ‎environment than in recent years. First, liquidity-starved markets tend to grossly underprice long-‎term value, especially in the case of highly leveraged independents: Their debt is difficult to ‎refinance in the current market conditions, and is pulling their market valuations down ‎substantially. The sharp share price drop in a number of upstream independents means they can ‎now be acquired for a fraction of what they would have cost a few months ago.‎

Second, because so many companies are stepping down their investments, scores of ‎experienced engineers working for IOCs and oil independents may be let go, while providers of ‎oil-field services (OFS) and engineering, procurement, and construction (EPC) services will likely ‎be forced to cut prices. Taking advantage of these, some companies have already stated their ‎intention to renegotiate the cost of their capital projects with suppliers. ‎

Third, the cost of the raw materials required for most large upstream projects has fallen ‎dramatically. “If there ever was a good time to invest in building oil upstream capabilities and ‎infrastructure, this would be it,” stated Chehade.‎

Certain aspects of a successful strategy for the times ahead will be common to all players: In this ‎credit-starved environment, they should focus on carefully managing their working capital, ‎controlling their costs, and fine-tuning business processes to maximize and accelerate cash ‎flows. In sorting the various players into four categories, depending on their competitive and ‎financial advantages, it is easier to discover, what the appropriate strategic action for each group ‎is.‎

1. Large IOCs, NOCs, and Super-majors with Access to Cash

A number of IOCs and NOCs currently have piles of cash. The five largest super-majors—Exxon, ‎Chevron, Shell, BP, and Total—increased their year-end cash and cash equivalents by nearly 24 ‎percent on average between 2006 and 2007, and by another 15 percent between the end of 2007 ‎and the last quarter of 2008, to nearly $80 billion in total. This should be weighted against their ‎degree of financial leverage. In nearly every case their volume of long-term debt over equity is ‎below 15 percent—relatively low.‎

Given secure financial positions, these companies have a unique opportunity to leverage the ‎prevalent market conditions for their benefit. “This explains why past periods of low oil prices ‎have seen significant market consolidation and why the most successful companies in ‎subsequent upturns have been those that went shopping aggressively when prices were down,” ‎explained Chehade.‎

2. NOCs with Access to Cheap Reserves‎

NOCs (particularly in North Africa and the Middle East) are enjoying privileged access to ‎untapped, conventional reserves of oil and natural gas, giving them exclusive access to cheap oil. ‎During the recent boom, these companies often found themselves unable to expand their ‎operations as fast as they wanted to and suffered acutely from a lack of technological capabilities ‎in certain key areas. Yet, as a result of the high prices of the past few years, these NOCs enjoy ‎very strong cash positions. ‎

Now is the time for these companies to invest in exploration and production and in developing or ‎acquiring missing technological capabilities to further their investment efforts. They should ‎consider hiring experienced engineers, or buying controlling stakes in oil independents or OFS or ‎EPC providers. The added technological know-how lets the NOC increase its output and proven ‎reserves and, on the other hand the purchased company increases its value through privileged ‎access to a steady flow of business with the NOC.‎

3. Oil Independents with Key Technological Know-how

Heavily impacted by the fall in the market value of their assets and often saddled with high levels ‎of debt, many oil independents are in a weak position. A strong business case can be made for ‎many upstream investments in the long term, yet these are not in a financial position to pursue ‎these opportunities in the way many IOCs and NOCs can. Under these conditions, a number of ‎firms may become classic M&A targets for companies currently holding cash positions well above ‎their operational needs. ‎

‎“At risk independents may want to be proactive and try to strike a deal on their own terms. There ‎are strong potential synergies for independents associating themselves with cash-rich NOCs with ‎access to cheap reserves and an interest in independents,” Chehade said.‎

4. Downstream NOCs with Local Market Dominance‎

Downstream NOCs often occupy an intermediate position across the other three clusters. These ‎do not enjoy privileged access to cheap oil reserves, so their power resides in their control of the ‎local downstream market. During the boom—many ventured into the upstream world, which ‎served them well as oil and gas prices climbed, putting pressure on downstream margins, and ‎now, many downstream NOCs find themselves in decent financial positions. Furthermore, local ‎governments regulate the prices at which many of these companies can sell their oil and gas.‎

Currently, IOCs with large cash holdings may view downstream NOCs as potential takeover ‎targets. Alternatively, downstream NOCs may themselves consider playing on the buyer side of ‎the takeover game. Ultimately, many will be able to afford a more focused, long-term strategy ‎than many independents. Their outlook for the future appears to be reasonably healthy.‎

‎ “With the gloomy market outlook, some energy companies may be tempted to reduce their ‎investment activity and minimize their exposure,” stated Chehade. This strategy makes sense—‎and a re-evaluation of operations and portfolio rationalization will be called for. Yet oil companies ‎with cash and NOCs with privileged access to cheap sources of oil and gas should pursue a more ‎active strategy. For those willing to take the long view, current market conditions constitute a rich ‎source of investment opportunities, potentially more solid and profitable than those into which so ‎much money went during the boom years.‎