Economic Challenges in Oil and Gas Industry

The report is devoted to the analysis of the issues of oil and gas industry, and revealing some trends. One of the biggest issues today is volatility. It means that it takes more time for production enterprises to consider the unpredictability factors in terms of supply or demand of the market. Moreover, rates of oil supply growth have not been so high lately, but demand is still stable, therefore the volumes of reserves have finally begun to decline. In spite of claims of professionals about signals of market development, companies are still having a number of severe problems. The first of them is about continuing contraction of activities focusing on discovering new formations. This leads to the second problem that has to be solved - reduction of exploration costs since the fall in oil prices in 2014. The next major issue facing the industry is supply disruptions. In some parts of the world, supply disruptions are associated with geological or political problems (for example, South America and Libya). Another factor holding back the growth of global oil enterprises is delayed maintenance. There is also a problem that companies face, connected with the difference between the increased capacities that they need and the limited capacities that they possess. Finally, the industry is facing a more general difficulty associated with moving the whole Earth towards a low-carbon economy.

Introduction

There is a number of reasons to believe that in the oil and gas industry, after a long-term crisis of overproduction, there may be a tendency towards its rapid movement towards the supply crisis. This is hard to believe, given the increasing rates of hydrocarbons’ production in US and the growth of optimistic opinions in the sector. Basically, the situation in the industry is much better than a year ago: oil prices have recovered. If some time ago it seemed that the price had settled in the range of about $ 45 to $ 50 per barrel, today Brent crude is trading at over $ 70. Thus, the industry is recovering after a difficult period when low prices have dominated over the past few years, strict financial discipline has been maintained, the asset portfolio has been restructured and high productivity has been ensured. At the same time, the International Energy Agency (IEA) in 2016 made an assumption concerning the probability of a supply crisis. And recently, the heads of Total, Eni and Saudi Aramco companies have warned of the possibility of a hydrocarbons’ supply crisis by the end of the decade. With growing demand for oil and given that investments in many large projects were postponed, there is a decrease in potential to meet this demand. Oil companies will need to increase production, and there is a risk that some of them may not be able to keep up with growing demand.

First of all, the basic problem of the sector is its inherent volatility. It will take time for manufacturers to take into account unpredictability in terms of excess supply or unmet market demand. In addition, they will have to overcome difficulties connected with the pace and scale of the conversion to the production of electricity from non-fossil sources. Given these uncertainties, oil and gas enterprises need to make a viable plan to minimize these risks. In other words, although the period of excess supply on the market is over, its consequences will be felt in the future. In the short term, companies must have strict financial discipline and pay particular attention to improving productivity and developing new technologies. In the long run, they need to restructure their asset portfolios so that they become profitable at low prices. In addition, they will have to consider how to ensure that their asset portfolio as a whole meets tomorrow's requirements and protect it in the context of a transition to a low-carbon economy.

Supply Difficulties

If we take a closer look at the recent recovery of the market in the short term, we can conclude that it meeting the demand over the next few years will become harder. Oil supply growth has slowed, demand is remaining stable, and inventory volumes finally began to decline. As for suppliers, OPEC played an important role in these regulations. With its decision together with non-OPEC countries, to reduce supplies by 1.8 million barrels per day during 2018, it accelerated the restoration of the balance of supply and demand.

According to forecasts, the volume of investment in exploration and production will increase in the medium term. The amount of drilling operations is growing in the oil and gas sector, and major projects are being approved. Here are just a few examples: BP has begun the construction of Phase 2 of the Mad Dog Floating Oil Platform in the Gulf of Mexico; Shell has made the final decision to invest in the resumption of development of the Penguins field, in its first new service facility in the northern North Sea in 30 years. The volume of exploration work is growing again for the first time since the start of the global economic crisis. Several companies have submitted applications for the latest auction, which held licenses for deep-sea shelf blocks in the Gulf of Mexico, and Shell received licenses for nine blocks), and Eni, Chevron and Repsol, as well as some other companies, increased their plots. In other regions, Tullow won offshore production licenses in Peru and Côte d'Ivoire, ExxonMobil goes to the deep sea shelf of Ghana and enters the Namibian market, and also begins exploration at oil and gas blocks in Mauritania, and BP, together with its Kosmos partnered with the development of an offshore field in Côte d'Ivoire.

Despite these signs of market recovery, sector enterprises face a number of serious challenges. The first problem concerns the ongoing reduction of activities aimed at discovering new deposits. By the end of 2017, the volume of discovered new oil and gas reserves was at the lowest level for the entire period since the beginning of the 1950s. To better understand the situation, the following data can be given: in 2017, reserves were discovered in the amount of only 3.5 billion barrels of liquid hydrocarbons (crude oil, gas condensate and a wide fraction of light hydrocarbons), which can satisfy the demand for these raw materials by only 10%. It is very simple to explain such a reduction: it is becoming increasingly difficult to detect large oil fields, and geological exploration has already been carried out in most of the promising areas.

This reduction is aggravated by the second negative factor: the low growth rates of exploration costs since they declined due to the collapse of prices in the middle of 2010s. Worldwide, costs have declined by more than 60% from a high of $ 153 billion in 2014 to about $ 58 billion in 2017. According to predictions, in the near future the cost will be restored at a moderate pace: the total average annual growth rate will be 7%. It is likely that a sharp decline in investment in the supply of traditional energy sources will continue to have an impact on the volume of production at new fields. Although there is a dynamic development in the production of a new energy source for American hard-to-recover oil, or shale oil, investments in energy sources produced by more conventional methods have fallen sharply, and as a result, it has been reported that it is necessary to annually find additional production volumes at new fields in the amount of 2.5 million barrels per day just to keep the extraction of traditional energy sources at the same level. Considering the fact that approximately six years have passed from the moment the project’s approval until the start of production, a decrease in the number of investment decisions made during the collapse of prices may further negatively affect the sector if the situation persists in which decisions on financial investments will be difficult. (IEA report “Prospects for the Development of World Energy” (2017))

The third major issue facing the industry is supply disruptions. Today on oil fields, levels of production are declining and the rate of decline in production is accelerating by about 4% per year. The current increase in costs in other areas is not enough to discover the new deposits in order to make up for the declining reserves. In some countries, these problems are associated with geological or political problems. For instance, due to economic difficulties in Venezuela, production in this country is reduced to about 1.5 million barrels per day, which represents a 40% decrease compared to 2.5 million barrels per day that were produced in that country at the beginning 2015 year. In the event of an economic collapse in the country, almost 2 million barrels per day would fall from the volume of oil supplies. In Libya, the actual production volume is about 990,000 barrels per day, which is significantly lower than the level of production in 2012, which was 1.5 million barrels per day. It is not yet clear how this difference will be made up. According to the US Energy Information Administration, due to the reduction in reserves, OPEC's free capacities at the end of 2017 amounted to 2.1 million barrels per day, i.e., they were almost 2 times lower compared to 4 million barrels per day in 2010 year. The fourth factor holding back the development of world oil production is deferred maintenance. In recent years, some operators have set aside minor costs for the future in order to reduce their costs. For example, on the UK continental shelf, the average number of man hours of outstanding work per one installation for corrective and deferred maintenance work, which are important for safety, increased by 25% from the 1st quarter of 2016 to the 4th quarter 2016 (according to the Safety and Health and Safety Report of the British Association of Oil and Gas Operators in 2017). Maintaining production levels at a certain level is important in any field, but in areas with outdated infrastructure it is critical.

After the recent failure of the Fortis pipeline in the North Sea, which led to a disruption in production in the region, problems related to an asset with a life of more than 40 years (the facility was opened in 1975) became apparent, despite the fact that the initial estimated life of the facility was approximately 25 years. The fifth difficult problem that operators face is the gap between the increased capacities that they need and the limited capacities that they have. Staff reductions made during a recession to save money, led to the loss of technical specialists and reduced the ability of the industry to attract promising youth. And all this in addition to the upcoming cardinal change of staff due to its aging and the absence of younger specialists with sufficient experience to replace employees who will retire. This is a demographic shift that will occur in the sector over the next ten years, when older workers will retire.

Finally, the industry is facing a more general challenge associated with moving the whole world towards a low-carbon economy. The growth of transport electrification, a potential one in BP’s publication “World Energy Development Forecast” (2018 and the widespread adoption of “smart” technologies for more efficient supply and demand management) will require the formation of new business models in the energy sector. With regard to oil production (including hard-to-recover oil) in the United States, it has grown significantly in recent years and currently the volume of production exceeds 10 million barrels per day, which is higher than the peak production level that was achieved in 1970. However, it remains unclear whether the United States will be able to cover the shortage of global oil supply in the future. From a financial point of view, American operators involved in the extraction of hard-to-recover oil are experiencing increasing pressure from investors demanding a shift from using the model of “general growth in production volumes” to conducting more profitable activities. In terms of operations, it should be noted that, as reported in the “Drilling Productivity Report” of the US Energy Information Administration, oil production from new wells per drilling rig in oil fields in the Permian basin rich in oil reserves began to decline due to depletion of stocks after the sharp growth demonstrated in early 2017.

Conclusion

Many industry participants still ignore the supply side of the global energy industry and are overly confident in the supply chain. Demand is still higher than annual forecasts, inventories are declining, and oil and gas are not replenished. Market value, such as backwardation (in which futures contracts are concluded at prices lower than expected market prices) and forward curves, reflects the belief that supply can be easily increased and that demand will stop growing and establish at a certain level. Nevertheless, the dependence of the whole world on oil and gas remains. In the short and medium term, the need to increase the supply of both of these energy sources will be felt more and more. It is very likely that volatility of fundamental market factors will continue, which will have an impact on oil prices. When operators evaluate the impact of various scenarios, from supply constraints to a low-carbon economy, they need an action plan. They need viable asset portfolios, they must innovate, and capital productivity and efficiency must remain the cornerstone of their business. In the longer term, companies will need an effective, well-balanced hydrocarbon strategy, a strategy that works regardless of what the future brings to these companies. Only those companies that take all these measures will have an advantage.