Taking a chance on oil - thinking beyond the oil market downturn

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%, 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 pre¬dictable 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 proj¬ects 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, includ¬ing 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 rene¬gotiate the cost of their capital proj¬ects with suppliers.

Third, the cost of the raw materi¬als 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 environ¬ment, they should focus on care¬fully 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, depend¬ing 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% on average between 2006 and 2007, and by another 15% between the end of 2007 and the last quarter of 2008, to nearly $80bn in total. This should be weighted against their degree of finan¬cial leverage. In nearly every case their volume of long-term debt over equity is below 15% - 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 explo¬ration and production and in developing or acquiring miss¬ing technological capabilities to further their investment efforts. They should consider hiring experi¬enced 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 tar¬gets 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 mar¬gins, 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 invest¬ment 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.