Capital & Economics

How Low Oil Prices Are Affecting The Global Economy

February 4th, 2016

Overview

After a year of decline in 2015, crude oil prices dipped below $28 a barrel in January 2016 – their lowest since 2003. The global oil marketplace is also set to see the arrival of new supplies from Iran, following the removal of sanctions, and U.S. production might also increase following Congress’ December vote to overturn the 40-year ban on crude oil exports.  Any further increase in global production could push prices lower still.

While prices were high, many oil and gas companies invested heavily in exploration and production, even in locations where production costs are high. After more than a year of low prices, some are now losing money. This is leading to an increase in distressed asset sales across the industry, debt restructuring, and layoffs, as well as consolidation through mergers and acquisitions. What’s more, the current disincentive to invest further in new reservoir development and extraction techniques may have long-term implications for both the industry and the wider economy.

Meanwhile, despite falling crude oil prices, the price of oil derivative products, including refined petroleum and petrochemicals, has not fallen as rapidly. Costs for end users may be down a little, but nothing like the 70 percent fall in prices seen in crude oil markets, so there has yet to be as much economic benefit from the fall in prices as many would expect.

With the future of oil, gas, and other energy prices still uncertain, we explore how low prices are affecting both the energy industry and the wider world, and the risks and opportunities they may present.


In Depth

How low oil prices are affecting the energy sector

It’s simple economics: Lower prices mean lower profit margins – or even losses. Lower profit margins mean less money for investment in new projects and production methods – and, in some cases, cutting back on existing operations.

By late 2015, according to industry consultant Graves & Co., oil and gas companies laid off more than 250,000 workers around the world.

Driven by low crude oil prices, the energy sector cut investment by $150 billion in 2015. Some analysts are predicting further falls in 2016, with one recent report from investment bank Tudor, Pickering, Hold & Co., stating, “Many exploration and production companies are virtually abandoning exploration altogether.” Recent auctions of Gulf of Mexico exploration rights showed the lowest level of interest in three decades, while similar sales off the west coast of Mexico drew no bids from the big producers. Shell abandoned plans for Arctic oil exploration in late 2015.

The lack of investment in finding new sources of oil and gas will have long-term consequences for production capacity, according to many analysts, particularly for deep water projects with long development times. Consumers may feel the impact of today’s lower investment today ten years from now.

The industry is all too aware of the challenge. Continuous investment is vital to ensure long-term production, secure new supplies and boost efficiency. But with oil prices as low as they are, return on investment has become so uncertain that producers have found it increasingly hard to secure the funding they need to develop more profitable approaches – a true Catch-22.

A distressed industry

In a low-profit environment, it is the most expensive forms of extraction and production that are being hit hardest. For the oil industry, this is primarily deep water drilling – with the Gulf of Mexico, the Atlantic coasts of Brazil and West Africa, and the North Sea oil fields the main areas being affected.

After hefty investments in costly new production facilities, many high-cost producers find themselves running low on cash. This has led several energy companies to seek to free up capital by selling off assets or restructuring their debt, with some even entering bankruptcy proceedings.

“The exploration and production companies are caught between a rock and a hard place, as we say in Texas,” says Bruce Jefferis, CEO of Aon Energy at Aon Risk Solutions. “Every day we hear about more de-listings, bankruptcies, debt restructurings, and the like. While many need to sell or merge to gain liquidity and capital for survival, no one wants to part with his or her company or assets when the prices are so depressed.”

As many as 75 percent of energy industry CFOs expect mergers and acquisitions within the industry to rise in 2016, as the industry seeks to consolidate in pursuit of improved efficiencies and longer-term gain. “If oil prices fall further, it will put immense pressure on failing companies to liquidate at fire-sale prices, and there are plenty of buyers just waiting for that to happen,” says Jefferis. “On the other hand if prices begin to rise, it might spur some investors to raise their offers to more attractive levels. In either scenario, M&A activity would be on the rise after the relative stalemate period we seem to be in now.”

To avoid sell-offs, some organizations are cutting back on their most expensive areas of production in a bid to preserve profitability. These are often offshore operations – where decommissioning can itself be expensive if done with the care needed to prevent potential environmental issues. Decommissioning could cost $46 billion in the North Sea alone. For those firms in extreme financial difficulty, this could be enough to tip them over the edge – which in turn could lead to operations shutting down in an unsafe way.

Because of this, governments are increasingly concerned about the potential for operators to default on decommissioning and environmental obligations, says Jefferis. The U.S. Bureau of Ocean Energy Management (B.O.E.M.) has recently proposed much stricter requirements for posting collateral for all offshore operators. “If it imposes substantially greater new requirements right now,” says Jefferis, “it might accelerate the financial crisis that it is trying to avoid. There are many on-going discussions between B.O.E.M. management and the offshore operators to find an acceptable path forward.”

Meanwhile, the industry still needs money, and that can provide opportunities for resourceful investors. There may be a short-term crisis, but long-term this is an industry that’s likely to remain highly profitable. “There is a lot of ‘dry powder’ with private equity companies and strategic investors looking to buy-in at what could be bargain rates,” says Jefferis.

But has oil fallen far enough to be a bargain? Jefferis says that’s difficult to ascertain. “Future oil prices are no more reliably predicted than for any other commodity or any stock market,” he says. “ The ‘experts’ have proven this by getting it wrong time and again during the latest cycle.”

The impact and opportunity for other businesses

Job cuts and lack of investment by energy producers can have a significant impact on businesses in the energy supply chain. A drop in orders for new drilling equipment can hit industrial suppliers, while job losses can have a significant impact on local economies. In Texas, it has been estimated that at least 56,000 people have lost their jobs in the industry, leading to falls in property prices in oil capital Houston, as well as predictions of more widespread job cuts at local businesses that aren’t in the energy business, according to the TCU Energy Institute.

But while low oil prices can hurt energy suppliers and energy-dependant regions, many people benefit from them, too. Although the drop in crude prices has not passed down intact to the gas pump, the American Automobile Association estimates that Americans saved more than $115 billion through petrol price cuts in 2015, more than $550 per driver. And businesses that use petrochemical derivatives like plastics – as well as the producers of those derivatives – have seen some cost reductions thanks to the falling price of their raw material.

So far the economic benefit from low oil prices has not been as pronounced as many had predicted, with the fall in oil prices estimated to have added only 0.5 percent to global GDP in 2015. Some have suggested this is due to many governments having already been subsidising fuel costs, while others have pointed out that it has historically taken two years for a fall in oil prices to impact global growth. This may mean that the true economic benefits begin to be seen this year.

Of course, the future remains uncertain. Things are changing fast, and the situation is growing more complex as multiple factors exacerbate and shift trends in both oil production and the wider economy. There are opportunities, and there are risks – and to gain the maximum advantage, businesses need to carefully assess their options.


Talking Points

“The fall in [oil] investment and asset prices is all the more harmful because it is so rapid. As oil collapses against the backdrop of a fragile world economy, it could trigger defaults… Oil plays a central role in a clutch of emerging markets prone to trouble… this oil shock comes as the world economy is still coping with the aftermath of the financial crash. You might think that there could be no better time for a boost. In fact, the world could yet be laid low by an oil monster on the prowl.” – The Economist, January 23, 2016

“If we wait for oil demand to recover it will take about three years, but we want to avoid conflicting with the oil majors… it is good timing to find distressed assets that small and midsized players may be pressured to sell off… We have overcome these tough periods in the past. We can’t afford to keep looking down. At times like now, we need to prepare new projects for the next decade.” – Tatsuo Yasunaga, CEO, Mitsui

“The prolonged period of low oil prices, combined with reduced investment and contract awards, is taking its toll on oil service companies in the North Sea and elsewhere. For some, this may be a time of opportunity when bargains can be had, generating attractive rewards for cash-rich investors such as private equity companies. But it is important to be aware of the risks involved in trying to acquire distressed businesses.” – Birgitte Karlsen, Partner, Wikborg Rein


Further Reading

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