With crude oil prices under $37 for the first time in the last seven years, the glut in the oil industry seems far from over. The Organisation of Petroleum Exporting Countries (OPEC), which was responsible for the bulk of global supplies, used to modulate production to control and maintain oil prices, so as to recover costs and sustain margins. As countries that were not part of OPEC started ramping up production, OPEC’s modulation became ineffective. Crude oil pricing now depends more on the free market forces of demand and supply.
In a bid to protect its market share and drive high-cost operators out of business, OPEC has maintained its production levels. This, coupled with a ramp-up in output from non-OPEC producers, has led to a situation where supply is higher than the projected demand. With this extra crude oil finding its way into global markets, the supply-demand dynamics have driven down prices.
Though low oil prices are a boon to consumers, it has put immense pressure on the oil companies to generate enough cash to sustain operations and repay their debts. As a first option, oil companies resorted to short-term tactics such as capex reduction, workforce optimisation and debt restructuring.
Long-term view
However, as the low oil price regime persists, companies have started taking a long-term view of the situation. With the oil and gas industry wiping out nearly $1.3 trillion of investor wealth in the last 18 months, investors and shareholders have started to aggressively persuade managements to take drastic measures to ensure profitability and sustained growth.
According to Dealogic, the global oil and gas sector saw $330 billion worth of M&A deals so far this year, making it the third most active sector for mergers and acquisitions, just behind the healthcare and technology sector. Though the number of deals has fallen, the M&A value has gone up due to some mega deals the industry has witnessed in the last 18 months.
While there is a belief in the market that oil companies are holding onto their assets due to low valuations, this data suggests the contrary. Companies with stressed balance sheets have gradually started to rationalise their asset portfolio to generate cash and reduce inefficiencies. On the other hand, companies that have substantial cash reserves have started to selectively acquire strategic assets and other firms, in a bid to expand their portfolio and grow bigger (see Table).
On the domestic front, low oil prices may augur well for a crude oil import-dependent economy such as India by keeping the fiscal deficit as well as current account deficit in check. India imported 80 per cent of its crude oil requirements in FY 2104-15 at an estimated $111 billion. Thanks to low prices, the crude import bill for this fiscal is currently expected to be around $73 billion, down 35 per cent from the previous fiscal.
India is the fourth largest consumer of energy in the world after China, the US and Russia. A large and growing population, coupled with an uptick in economic activities, will only add to energy consumption in the coming years. With less than 1 per cent of proven global reserves and more than 4 per cent of global consumption, the Indian oil and gas sector faces the daunting task of meeting domestic demand and ensuring a reserve replacement ratio of more than 1.
Acquiring assets
It is the usual practice that, with a reduction in oil prices, extensive and expensive exploration activities are curtailed. However, as the oil industry is known to be a cyclical sector, most industry analysts believe that the current transient situation of low oil prices will not last forever. Sooner or later, crude oil prices will bounce back as the supply-demand gap closes.
To deal with that situation, India must increase self-reliance by a) boosting domestic oil and gas production, and b) reserve accretion using inorganic methods (equity oil investments overseas). As low oil prices drive down valuations, acquisition opportunities in operating assets will be favourably priced. Shoring up our oil and gas reserves is a critical step in ensuring energy security for the nation.
(The views expressed are personal)