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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, a new report by Booz & Company concludes.
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,” comments Georges Chehade, a partner at Booz & Company.
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 per cent, 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 report points out that oil prices are now 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 US. 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.
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.
Companies with cash and the willingness to invest will encounter a much more favourable 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 proj¬ects 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.