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Anthony Lobo, head of oil and gas at KPMG, on the pros and cons of oil market instability

11th February 2015

Anthony Lobo, head of oil and gas at KPMG, talks to Mark Venables about possible low oil price scenarious

Mark Venables speaks to Anthony Lobo, head of oil and gas at KPMG about the challenges faced by the oil and gas industry in the wake of the recent oil price slump

Mark Venables speaks to Anthony Lobo, head of oil and gas at KPMG about the challenges faced by the oil and gas industry in the wake of the recent oil price slump
'Not only does a low oil price put pressure on oil companies, but it also creates a ripple effect right through the supply chain and beyond'

Oil & Gas Technology: How prepared was the oil and gas industry for the slump in oil prices?

Anthony Lobo: While the refusal by Saudi Arabia to announce production cuts at the November OPEC meeting sent the price into free fall, it was perhaps not a significant surprise to the industry.

To date, the main announcements have been from the international oil companies, many of which have signalled significant reductions in capital expenditure and the lag between these announcements and the knock on impact will be key.

Handing back exploration licences is all very well, but cutting maintenance capital expenditure could increase depletion rates in the nearer term and reduce production levels in the medium term (one per cent increase in depletion rates could reduce production by 1mbbl/d).

 

What do you think the short-term affect will be on E&P operations?

In the short term, companies will maximise production to maximise cash flow, whilst also cutting capital expenditure to preserve cash flow. A further round of announcements about cuts, and write-downs, should be expected with the next set of quarterly earnings. Companies will be looking at the two year forward prices as appropriate to their planning horizon.

 

What do you think the long-term affect will be on the E&P operations?

There are opportunities for companies with financial resources to acquire assets or lock in far lower project costs and if managements can be brave they should, although the equity markets are not likely to reward them in the short to medium term.

 

Are some companies better cushioned against this slump?

Large companies with more quantum of central cost and more sway with suppliers and contractors are likely to be more resilient and can make adjustments with a broader portfolio of projects.

 

Are there any particular groups or types of services that will be particularly badly hit?

Smaller companies and marginal shale producers without strong balance sheets and access to funding, may struggle to weather the storm, particularly if there are further price falls in the pipeline. We’ve already seen significant cutbacks to capital expenditure for 2015 across the industry as a whole, however, we’re yet to see scale-backs to production.  This will have a knock-on effect for the oil field services industry.

 

How is the oil price changing the strategies of E&P companies?

The continued slide in the oil price means that cutting-back exploration costs and discretionary capital expenditure may no longer be enough to cover company overheads and committed capital expenditure.

Companies are beginning to seek quick cost savings solutions, and we could now see dividend payments coming under closer scrutiny. Funding dividends through borrowings might be a potential option, as operating cash flows may no longer cover them. However with the possibility of the lower oil price continuing for the foreseeable future, companies will need to think carefully on whether this is a sustainable solution.

 

Thinking about the supply chain and service companies, how is this affecting their business?

Not only does a low oil price put pressure on oil companies, but it also creates a ripple effect right through the supply chain and beyond.  The initial response we have seen from oil executives has been to revise their forecasts, particularly this year, by stopping and deferring non-essential spend. These actions have been smoke signals for companies serving the supply chain.

We are likely to see a wave of procurement led activity, to review historic contracts for compliance and claw back overpayments, attempts to consolidate suppliers, rate renegotiations and more robust approaches to contract lifecycle management. This activity may result in a change in relationship between oil companies and service suppliers as contracts get renegotiated.

 

Are there any technologies or services that can take advantage in what is now a cost-sensitive market?

Oil traders with access to storage facilities are benefitting from the contango market. This means traders are not forced to sell at the current spot price, instead, they can store the oil and lock-in a higher future price - providing shareholders with almost risk-free profits.

As with any market disruption, necessity is the mother of invention and so for the more mature and nimble service companies, there will be the opportunity to collaborate with each other.

This will drive alternative commercial arrangements in which both oil company and supplier can gain the benefits from reducing the cost base.

 

What are your expectations, short- and long-term, for oil prices?

Oversupply looks set to continue at least for the first half of 2015. Therefore, industry actions will not affect output earlier than the latter part of 2015, and perhaps even later, given the improving productivity within US shale. This could result in a lower oil price, which could even dip below USD 40, during the first half of this year.

Looking ahead, the longer it takes for the market to adjust, the greater the risk of continued weakness. In the absence of a concerted cut in production by the industry, there is no natural floor for the price.

 

Will the slump in oil price herald some consolidation within the OG sector?

We can certainly expect low oil prices to spur consolidation within the sector. As we have seen, the oil industry is rapidly trying to adapt to the newly volatile oil prices.

Restructuring, slashed capital expenditure and delayed exploration have all been announced, as the big players seek to maintain cash flows to cover dividends, while smaller companies struggle to access new debt‎.

 

What type of M&A would you expect to see in the sector?

Majors with courage, strong capital and a long-term view, could run a slide rule over corporate acquisition targets, as share prices have been at their lowest in the past year. While many majors are already looking, the question is who will be first to move.

Amongst the areas where we can expect to see mergers in the sector, is the US shale market, where there are good assets owned by companies that have come under significant pressure as a result of the low oil price. This could potentially be a good route for super-majors with a bold vision and capital looking to enter the market.

 

In such a market is it inevitable that some companies that have over-stretched will be ripe for acquisition?

From the acquisition side, the low oil price is putting pressure on margins, creating an unsustainable situation where the return on equity is below the cost of capital.

From the buyer’s side, those with the money and potentially the interest are the private equity and national oil companies (NOCs). 

 

Who will be the big winners and losers in this scenario?

National oil companies (NOCs) with a strategy to internationalise may well be very active as the lower oil price will give them the opportunity to expand beyond national boundaries. International oil companies may also see this as a window to balance their portfolio, particularly exploration which has been significantly discounted.

Private equity has certainly raised an enormous amount of money (estimated at USD 50bn by April 2013) for investment in oil and gas. However, this level of uncertainty, and minimal chances of an exit via flotation in the next few years, means the climate is more akin to venture capital. With to the need for funding in the earlier stages of projects, there is potential to sell to other private equity funds as the projects mature.

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