Surviving 2015

Over the past year, some significant changes have taken place in the energy sector. Affected most notably by the vast drop in the oil price during the second half of 2014, the shale industry has been forced to face a number of critical challenges, which could threaten its future success.

Conditions for a crash

While many blamed OPEC and in particular, Saudi Arabia, for the crash that sent Brent crude prices plummeting from US$114/bbl in July 2014 to US$59 in mid December 2014, two other key factors predating OPEC’s refusal to cut production had combined to create the conditions for major change.

First, forecasts for China’s oil demand had been unrealistically inflated based on the assumption that, in spite of a well publicised slowdown in economic growth, demand for oil would continue to grow. In fact, that slowdown combined with a surge in the country’s own refining industry contributed to the disintegration of growth in demand for oil products in China to the slowest growth rate since 2000, according to a report by ICIS.¹ If one adds to that the gradual decrease in demand for fuel in Europe due to economic weakness, one can see an overall decrease in demand for oil worldwide.

Second, the consistent production from new shale plays in North America and Canada resulted in a large increase in worldwide crude oil supply. Combined with OPEC’s refusal to cut its own production, a drastic drop in the price of oil was perhaps not too surprising.

Effect on the shale fields

The primary effect of the oil price tumble has been a requisite plunge in the share prices of key shale play holders and service companies. Suppliers for production companies in Russia are also feeling the pinch. Already restricted by sanctions imposed by the US and the EU following Russia’s annexing of Ukraine, service providers are suffering further from the effects of the oil glut.

While a decline in investment will likely contribute to lower production, the end of shale investment is not necessarily on the horizon. In the short term, those shale producers who are financed by a high level of debt and cannot withstand the low prices could indeed go out of business, but the larger and perhaps better financed projects should survive. Even if projects are put on ice at the moment, any reduction in the amount of oil available on the market will have the obvious result of supporting a price increase in the long term, bringing profitability back to a comfortable level.

Additionally, huge advances have been made in fracking technology, so that the time and costs of drilling new wells and extracting more oil from existing ones have both declined. This has reduced operating costs enough that the oil price needed to make a profit has also gone down, relieving some of the pressure.

Short term respite for Europe

The effect that these changes have in turn had on the feedstock used in refineries both in the US and in Europe has also been significant. While more than 50% of global ethylene, used to make polyethylene for plastic manufacturing, is created from naphtha cracking, the trend over recent years has been a widespread decrease in the margins of refiners cracking naphtha compared to those enjoyed by the ethane crackers.

Due primarily to the wide availability of ethane generated from domestically processed shale, American refiners have been able to buy cheap feedstock at home while also benefitting from the higher percentage of ethylene produced when cracking ethane. Combined with the fact that chemical prices tend to follow Brent and WTI crude prices (and not Henry Hub), the 'Shalemen' of the US have enjoyed quite some advantage from buying feedstock cheaply and selling products at a high price. By comparison, as European infrastructure has typically been built around naphtha cracking refiners in Europe were squeezed both by increased competition from abroad and higher feedstock prices.

Considering the recent plummeting of Brent and WTI crude however, the cost of naphtha has also gone down significantly, offering some cost respite for the naphtha crackers. While it should be noted that chemical prices tend to follow the oil price and therefore buyers have more power to dictate lower chemical prices when the oil price falls, the cost advantage of cracking ethane has nevertheless been cut back and with it, the competitive advantage previously enjoyed by the ethane crackers.

Conclusion

In light of such dramatic changes in the market and because there is essentially very little that individual companies can do to control them, the focus from Boards must be on what can be controlled: fixed costs. Managers must look hard at their operating practices and question existing assumptions about effectiveness and efficiency in terms of maintenance, shutdowns and capital expenditure, which together can impact efficiency by as much as 25%.

If Saudi Arabia keeps production up and the more vulnerable shale wells stop drilling now, there is no reason why they cannot be reactivated in the future. Equally, those who stay ahead of technological developments and remain prudent with regard to production, operations and expenditure will survive and will be well placed to take advantage of weaker plays looking for a quick sale. While the Saudis may appear stronger in the short term, the tenacity of the American investors should not be underestimated: this is a plot with more twists to come.

Written by Dirk Frame, T.A. Cook Consultants. This is an abridged article from Hydrocarbon Engineering’s March 2015 issue.

References

• ICIS China Annual Petroleum Report.

Read the article online at: https://www.hydrocarbonengineering.com/special-reports/27022015/surviving-2015-335/