Oil: Doom & Gloom

The fallout from low oil prices extends to every level of the global supply chain.

By Paul Benecki

Over the last year and a half the price of crude fell from over $110 a barrel to less than $30, well below the average breakeven for offshore drilling. The global oil industry has shed an estimated 250,000 jobs since the downturn began with many more layoffs predicted. In an environment of unrelenting oversupply, most analysts predict that oil is likely to trade in the $40 to $50 range until at least mid-2017 with any turnaround in offshore activity lagging a price recovery by as much as a year or more.

There are several contributors to the pessimistic outlook, among them high-volume Saudi Arabian and Iraqi output, the return of Iranian oil to the global market, and the ability of U.S. shale firms to ramp up production once prices rise. U.S. drilling activity is at its lowest level since records began in 1949, but analysts say shale producers have used the tough market to cut overhead and can now operate at much lower prices than in years past. The sector's ability to quickly raise production at a low break-even is "putting a cap on oil prices" for the near future, says John Kilduff, a partner at Again Capital.

No Relief in Sight

If reasons for bullish expectations exist, they are few and far between. Saudi Arabia and Russia proposed an output freeze early in 2016, but the potential for an agreement is still dependent on other producers, says Scott Modell, Managing Director of The Rapidan Group: “OPEC is Saudi Arabia, and Saudi Arabia won't cut output until it checks a few boxes: One, Iran has to cut; two, Iraq has to cut; and three, shale oil won't bounce back.”

As of March the prospects for all three appeared limited. Shale producers intend to rebound. Iraq's government depends heavily on oil revenues to operate, and Iranian Minister of Petroleum Bijan Zangeneh recently described the idea of a production freeze as “a joke.”

What's more, Tehran is ramping up exports in a running price war with Saudi Arabia, Modell says: “The Iranians are eager to claw back lost market share. Iran recently matched Saudi adjustments for equivalent crude grades into Asia and the Mediterranean and undercut Saudi adjustments into NW Europe. So yes, there is a price war, to the Iranians' chagrin, given their history of avoiding discounts.”

Despite the bargain pricing, Iran has only managed to raise exports by 220,000 barrels per day since sanctions eased, according to the International Energy Agency (IEA), and much of this volume has been from storage. Part of the slow pace is procedural: Oil traders, banks and P&I clubs say that U.S. sanctions remain a hurdle.

While a European company might be technically free to transact with Tehran now that nuclear sanctions have been lifted, the U.S. Treasury's Office of Foreign Asset Control still restricts an American firm's ability to make the same deal, and enterprises in Europe often have strong ties to U.S. entities, potentially exposing them to liability. Additionally, the previous sanctions regime could be swiftly reimposed if Tehran reneges on its promise to curtail nuclear activity.

With these challenges and others, it appears that Iran’s return to the global market will be gradual, says the IEA. Modell expects that the Islamic Republic's exports will rise by another 500,000 barrels by the end of the year – less than what Iranian officials promise, but still more than what other producers would like.

With an oversupplied market ahead and an ocean of oil in the global storage inventory – over three billion barrels in the OECD alone, with over a million more every day – only the projects offering the lowest breakeven and largest recoverable reserves are moving forward. Notable areas of current activity include:

• offshore Brazil, where Shell recently announced its intent to quadruple its regional output (and where scandal-ridden Petrobras is pulling back);
• offshore Uruguay, with new investments from Statoil and Total in Blocks 14 and 15;
• the Johan Sverdrup project in the North Sea, with expected peak production equal to 25 percent of Norway's total, and
• the Persian Gulf, with five-year commitments from Saudi Aramco and Adnoc totaling $50 billion, according to Dr. Hassan Abouraya, an executive with Saudi firm Zamil Offshore.

For the limited offshore work that remains, the competitive pressures are intense. As profit margins for E&P firms have plummeted, they have pushed to save on rig chartering, which has historically accounted for as much as a quarter of capital expenditures on offshore projects, according to McKinsey & Co. With as much as 40 percent of the world's semi-submersibles and jackups sitting idle, and more being cold-stacked or scrapped every month, oil majors have plenty of leverage to demand low rates on the best, newest equipment. Analytics firm RigLogix says the average day rate for a rig fell from $400,000 to $260,000 over the course of 2015.

Pricing Pressure

The pricing pressure gets passed down the supply chain, and the same overcapacity problem exists throughout. Gulfmark CEO Quintin Kneen recently estimated that the world's OSV fleet is at 50 percent utilization, and operators are reportedly getting day rates 40 to 60 percent below the levels of yesteryear. However, Bourbon Offshore says it is retaining 80 percent utilization with its relatively new 500-vessel fleet. With every offshore vessel firm offering rock-bottom rates and immediate availability, oil majors prefer the high-spec ships and long track record of the more established companies, Bourbon claims.

While the biggest global operators retain an advantage, others are forced to look far afield for new business, bringing with them their own pricing pressures. Singapore-based POSH has begun bidding and winning contracts in the Persian Gulf, much to the dismay of local shipowners. Vivek Seth, CEO of Qatar-based Halul Offshore, recently said that “With Southeast Asian owners moving tonnage into the Middle East, rates have fallen by 50 percent to breakeven levels.” 

Zamil Offshore's Abouraya suggested that national oil companies are using the low out-of-region bids not only to secure future prices but “to renegotiate even lower rates on prevailing charters’ terms and conditions,” cutting Middle East operators' margins immediately.

The companies serving rigs and offshore vessels feel the pinch too. “The oil majors are passing down their requests for cost-cutting to all tiers in the service industry, to 'share in the pain' of this poor market by cutting costs or offering opportunities to reduce the cost,” says Rick Shilling, Chief Operating Officer for diving firm Subsea Global Solutions.

A competing provider of rig inspection services believes that with declining margins the business case for many service firms isn't there anymore. “This market is crazy,” he says. “I don't see this in any other market in the world where people will put out $8-10 million for a remotely operated vehicle and then charge $3,000 a day.” But in an environment of huge oversupply, they no longer have the pricing power to charge more.

“No Valuations Anymore”

A further result is that many offshore service businesses aren't worth what they used to be – or perhaps even anything at all. Private equity investors say there are no valuations anymore. Service company valuations have disappeared because no one wants to buy an asset that doesn't have value. That’s why no one’s getting bought up. The established players would rather sit back and see their competitors go away and get their market share back.

For some, the new pressures come with new opportunities. Procurement managers are reportedly showing new interest in small, asset-light service companies, provided their service can keep a platform or drillship on-hire. Shilling agrees that uninterrupted operations are key to winning business in this market: “For vessels and rigs that have remained in contracts and working, the importance of our service has grown as there is a glut of equipment available in the market to take over their charters.”

Demand is down for shoreside suppliers as well. Eric Kotteman, a representative with rigging supplies firm LGH in Louisiana, says he has seen a “sizable decrease” in business from shipyards, rigs and OSV operators in the Gulf of Mexico. Clients haven't tried to negotiate for lower prices, and they're not shopping elsewhere. They just don't have much work, and don't expect to for some time. His firm is ready to serve its customers when business rebounds, but he predicts that “oil will have to increase its price back to $80 per barrel before operators and technicians can invest in projects that are beyond simple maintenance.”

Feeling the Pain

Kotteman sees the impact in the broader community, too. “There have been massive layoffs since the decline,” he says. “Not just in drilling and production but everywhere, from the groceries stores, the helicopter companies, full-time and part-time employment agencies, and all the trades as well.”

This is the human cost of “lower-for-longer” oil. The oversupply of crude means a highly competitive offshore industry, but it also means hard times ahead for thousands of working families around the world. – MarEx  

Paul Benecki is a staff reporter for The Maritime Executive.