Will Offshore Exploration Fall Victim to Low Oil Prices?

Mid-June 2014 marked the peak in the world oil market as measured by the spot price for North Sea Brent oil, the industry’s global benchmark, which hit $115.19 a barrel. From then until February 23, the price dropped by 48 percent to $59.78. The decline was greater for the U.S. benchmark of West Texas Intermediate, which fell by 54 percent from $107.95 to $49.56 a barrel.

Cutting oil prices essentially in half was probably not what Saudi Arabian leaders had in mind when they stood firm against pressure from their fellow OPEC members and other oil-producing nations such as Russia and Mexico to cut their output to support global oil prices then in the $70 a barrel range on Thanksgiving Day. But that’s what happened.  

Saudi Bear Hug

By electing to hold production steady and leave price-setting decisions up to the marketplace, Saudi Arabia was acknowledging that the oil world had changed. Exactly how it had changed and how key oil producers could fix it remain open for discussion. But Saudi Arabia elected not to participate in that debate. It was content to let market forces sort out the equilibrium price for oil, knowing that lower prices strengthened their longer-term position.  

Much time and effort has been expended by analysts and reporters trying to scope out what was, or is, behind the Saudi decision. Were they trying to shut down America’s fracking revolution? Or targeting Russia’s economy, which is highly dependent on crude oil and natural gas exports, as punishment for Vladimir Putin’s support of Saudi Arabia’s Middle East nemesis, Iran? It’s even possible that Saudi’s fellow OPEC members were the target since many of them refuse to reduce output when market conditions mandate they do so to help balance global supply and demand, so they effectively free-ride on Saudi’s production cuts.

It may also be that Saudi Arabia’s leaders are seriously concerned about the kingdom’s eroding market share in a world where oil demand growth remains anemic and other producers, especially in North America, are seizing market opportunities. If you only have oil to sell and you set your sights on the long-term outlook for your country, a shrinking market due to weak demand and increased competition suggests a bleak future.

About a month after that fateful OPEC meeting of November 27, the Wall Street Journal quoted Qatari Oil Minister Mohammed Bin Saleh al-Sada as saying, “Those who cannot stand the pressure of lower prices will have to step down and give way to those who can do better in terms of efficiency.” That statement crystalized the future for the global oil industry: Become more efficient and lower your costs or you will be left behind to stagnate or disappear. And it raises the question: Who will be the survivors and, more importantly, who will falter?

In mid-January we were preparing to board a flight from Houston to Calgary. We struck up a conversation with the gentleman behind us, a retired Shell Oil petroleum engineer. He was on his way to a consulting client involved in Canada’s oil sands. Global oil prices at that time were in the mid-$40s. We discussed the pressure on his client, who was desperately trying to improve his operating performance, which our engineer thought was unlikely. Thus he expected his gig in Calgary to be ending once management confronted the reality that their costs couldn’t be reduced sufficiently to match the low oil price.  

Canada’s oil sands business is heavily capital-intensive and only prospers in high oil-price environments. These long-lived projects were likely one target that Saudi Arabia had in mind when it made its oil-output decision in late November.

The engineer and I then discussed his other gig – working for Saudi Aramco, the national oil company of Saudi Arabia. Given his background in unconventional production, he was assigned to the team of professionals charged with determining the breakeven prices for all the shale plays in North America, but perhaps more importantly to help educate Aramco as to how those companies would respond in a low oil-price environment.

Surprisingly, Saudi Aramco doesn’t appear to have a similar team assessing the impact of low oil prices and technological improvements on the future of offshore exploration and development, especially deepwater. Could it be because they have overlooked this source of global oil supply? Or might it be that the timeframe in which Saudi envisions oil prices remaining low will not result in many of these projects being cancelled, but rather just delayed?  

Deepwater Bright Spot

Deepwater oil production remains a bright spot in the long-term outlook for the global oil industry. A recent analysis of the offshore market by Norwegian consultant Rystad Energy suggests that, despite the drop in oil prices, deepwater and mid-water oil output will remain growth markets through 2025.

The growth comes partly in response to the dramatic slowing in output from shale and tight oil formations. And shallow offshore waters probably hold little hope for meaningful oil output growth because they have been highly explored and developed, leaving few new areas of opportunity.  

The Rystad analysis estimates that between 2010 and 2013 production from all three offshore water depths declined slightly (by two or three percent). Production growth came primarily from shale/tight formations (up 72 percent) and oil sands (up nine percent). Turning to the future, the mix of output growth will be considerably different. Rystad projects that between 2013 and 2025 shale/tight oil formations and oil sands will only expand their output by nine and seven percent, respectively. On the other hand, deepwater output is projected to grow by nine percent while mid-water increases two percent and shallow water remains flat.  

For this forecast to be realized, the offshore drilling and support industries will need to make meaningful adjustments to their enterprises. These adjustments appear to be already underway as demonstrated by the fact that two large drilling companies – Diamond Offshore and Transocean – are scrapping a total of 18 floating drilling rigs from their fleets. These rigs represent older, low-specification units.

For long-time participants in the offshore industry, these moves were surprising as many of the units being sent to scrap yards to be cut up are rigs these individuals remember being built early in their careers. There is little room for nostalgia in today’s energy business!

The New Reality

Low oil prices are impacting offshore drilling and development activity as virtually every international major and national oil company is being forced to live within its sharply reduced cash flow. Those companies that are publically-owned must balance multiple considerations: finding new oil and gas reserves, growing production, sustaining their organizations and continuing to reward shareholders. With oil prices having been cut in half, cash flows are sharply reduced.  

The prospect that this condition might last for several years has largely shut the door for companies seeking to access the capital markets. So cutting capital spending, including exploration and development projects, gets top priority. Companies must right-size their organizations, meaning laying off employees, at exactly the moment when the older generation is retiring, leaving management with the dilemma of how to retain younger, less-experienced staff without losing too much institutional history.  

Companies have been reluctant to cut their dividends, recognizing that one of the principal attractions of their shares has been their lofty yields, and without them their share prices would trade substantially lower. For many companies, however, balance sheet and cash flow considerations are forcing dividends to be slashed or eliminated, a cost that will be paid for in the future.  

Another challenge has been the impact of regulatory costs. In the Gulf of Mexico since the Macondo oil spill in 2010, the time needed to drill wells has increased by 13 percent.  Operations have been further impacted by the rising cost of skilled workers and drilling supplies, such that the combination of these factors has inflated the total cost for offshore wells by 25 percent over the past four years, an unstainable rate of increase.  

Despite record offshore spending, oil and gas discoveries recently hit a 60-year low. As a result, operators and contractors will strive to eliminate inefficient units and reduce day rates for other equipment, crimping their owners’ returns. The offshore industry’s rig fleet will appear to shrink as older rigs retire. But equipment retirements just establish a smaller fleet from which to measure industry growth. Based on current order books for offshore rigs and support vessels, the total fleet should grow by about five percent this year and 17 percent by 2020. Much like Mark Twain, the predictions of the demise of the offshore drilling business due to the collapse of global oil prices have been greatly exaggerated. – MarEx