Vol 13 (2016) - Issue 3

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Navigating the Risks and Opportunities around Counterparties in a Low Oil Price Environment

There is no doubt that the low oil price environment is putting the oil and gas industry under significant strain. The oil price has slumped by approximately 60% since mid-2014 – a level of decline in product value that would already have heavily damaged many other industries.
The industry has been shielded from the worst effects of these initial falls by several years of strong profitability and high cash balances. This provided a cash cushion through 2015 while companies looked at cost-cutting programs largely focused on people costs. There was also capacity for greater operational efficiencies to be introduced to mitigate the lower price. Most operators did not have much difficulty in finding the first 15-20% of capital expenditure cuts; indeed, one oil company CFO to whom we spoke admitted that he almost welcomed the fall in prices – it had given him the opportunity he needed to drive operational efficiencies covering areas from exploration costs to expense claims in order to make the business leaner.
Nonetheless the fall in barrel prices has been very significant, and the longer the oil price stays low, the greater the pressure on the industry will be.
There are some parts of the world, such as the Middle East, where it is still possible to operate profitably at today’s low price mark. But in other regions, such as the North Sea, the outlook is very challenging. Demand is largely static, supply is increasing and indeed there is already a surplus; while rig and other costs are largely fixed and must come down significantly. The lower oil price is also making fields which were previously marginally profitable increasingly uneconomic, in terms of recovery, accelerating the likelihood of production ceasing and the need for decommissioning, with all the costs that it entails, being brought forward.
All of this means that, if the oil price carries on running at depressed levels for the rest of this year and into 2017, as most analysts are predicting, then the risk of distressed situations is going to become increasingly acute.
That said, the oil industry is a complex, multi-layered sector with many different kinds of players, all of whom are affected differently. For the majors, whilst their upstream businesses have been hit by the fall in oil price, their downstream businesses are actually doing well; the lower oil price means they need to tie up much less liquidity in working capital.
Meanwhile, oil field service companies, who supply the exploration and production (E&P) companies, have been affected to varying degrees. Generally speaking, the further down the chain a company is, the harder it has become to make a profit, and especially if it is operating in a niche space.
There have been some insolvencies in the sector to date, where assets have been sold and the corporate liquidated without any significant knock on impacts affecting the companies’ counterparties. Stakeholders, from suppliers to creditors, have been supportive of the changes which may be needed in order to help a counterparty address an immediate challenge. These range from a counterparty voluntarily agreeing to amend contract terms or reduce margins in exchange for a longer contract length, to lenders agreeing to amend covenants to avoid a default under the original facility to give borrowers time to adjust to falling prices and assess what operational changes may be needed.
The options available to counterparties will become narrower, and their implementation more difficult, as oil prices remain lower for longer. One area which is increasingly coming under the spotlight is joint venture agreements in E&P.

JVs – assets or liabilities?
Joint ventures (JVs) have always been widely used by oil companies, to partner both with other oil companies, who can bring different skills and experiences, and also with National Oil Companies and Governments.
The use of a JV to share knowledge and experience, as well as to share risk, is perfectly sound and sensible business practice. And while JVs mean that all partners become reliant on each other to fulfil their respective roles and contribute their financial shares, if one party were to default then the upside for the others is often that they distribute that partner’s equity share between them for free. And when the equity is in the money, in the good times at least, a JV default did not appear particularly troublesome for other JV partners, and might even have represented a windfall gain.