Oil prices have recovered somewhat from the lows in August, but current prices are still well below the break-even oil price for the vast majority of oil companies. High oil inventories and weak manufacturing data from around the world would seem to suggest that oil prices will likely to stay “lower for longer”. Analysts at investment bank Goldman Sachs go further, suggesting the price of oil could fall to as low as $20 per barrel.
With oil prices likely to remain below the break-even price that oil producers need, banks have been tightening credit to oil producers. And without the ability to borrow, many oil producers could struggle to fund investments and afford their regular dividend payments.
The shares of BP (LSE: BP) and Royal Dutch Shell (LSE: RDSA)(LSE: RDSB) have performed much better than the shares of most smaller oil and gas players. This is because the two oil majors benefit from stronger balance sheets, better access to capital markets and, most importantly, diversification in the form of their downstream operations.
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Higher downstream earnings has partly offset the decline in upstream earnings for BP and Shell, and explains the more modest declines in operating cash flows. BP and Shell’s operating cash flow in the second quarter of 2015 declined by only 20% and 30% respectively, which explains why they have been able to sustain their dividend policies.
The growth in downstream earnings acts as buffer against lower oil prices. Refiners benefit from higher margins under such conditions, as they are able to take advantage of the dislocations in the oil market, and the price of refined products are generally sticky and less sensitive to changes in the price of crude oil.
But Shell has made a series of high-cost and high-risk investments, including its Arctic oil exploration, investment in LNG facilities in the Russian Far East and, most importantly, its BG acquisition. These investments would most likely increase Shell’s break-even oil price and put itself in a weak position to cope with “lower for longer” oil prices.
However, Shell is not being complacent. It has announced $4 billion worth of cuts to its annual operating expenses, reduced its capital expenditure budget by 20% this year and, most recently, announced a halt to its expensive Arctic drilling plans.
BP, which faces fewer execution risks and is moving on from the Deepwater Horizon oil spill, has acted more swiftly and more boldly in reacting to lower oil prices. It has set a new break-even oil price target of $60 a barrel for new developments, and has cut its capex budget more substantially. The company has also sold peripheral assets and embarked on its cost-cutting plan earlier than its peers.
Tullow Oil‘s (LSE: TLW) reliance on debt puts it in a weak position to weather the low oil price environment. Despite being one of the industry’s lowest-cost producers, with cash operating costs of around $18 per barrel of oil, Tullow needs debt to fund its investments in production and exploration activity.
With lower oil prices being a constraint on the company’s ability to generate cash flows, banks will likely become increasingly reluctant to extend credit that the company will need to get through the downturn. Tullow has cash and undrawn credit facilities amounting to $2.1 billion, but unless it makes further cuts its investment programme, I believe it will not have enough cash to last more than 2-3 years in today’s low oil price environment.
All three companies can easily survive over the next few years, but more radical change is probably needed to cope with “lower for longer” oil prices. For BP and Shell, this would probably involve cuts to their dividends or further reductions in capex and more asset sales. Tullow, which has already suspended its dividend, will have fewer options.
