study, links and strategic recommendations based on...

Study, Links and Strategic Recommendations based on previous Crude Oil

Price Shocks

Yaerid Jacob

[email protected]

IESE Business School – University of Navarra

Individual Study Paper – June 2017

Abstract

Since 1970 there have been several crude oil price shocks that have had significant impact on both oil importing and

exporting economies. In 2014, when the oil & gas industry started seeing volatility again, an individual look and

analysis of each of the prior major oil price shocks led to the discovery of multiple commonalities between these past

shocks. Some of these commonalities are –

1. Rise of a Competing Nation/ Loss of OPEC’s Influence

2. War or Civil Unrest in Exporting/Importing/Transporting Countries

3. New Technologies/ Alternative Sources of Energy

4. Strength of the Dollar and Fed Funds Rate

Based on these commonalities/indicators, which will be delved into more detail later in the study, a few strategies for

companies to best counter some of the risks that investments come with were developed. If companies on seeing these

indicators implement certain recommended strategies (i.e. cost efficiency initiatives, early adoption of technology,

decentralization of operations/JVs, hedging tactics, etc.), they can minimize their downside risks and be ready to grow

when market conditions are favorable.

The Major Oil Shocks and their Prevalent Causes

In this paper, you will see that every major oil price shock has been caused by a multitude of events happening

simultaneously. The impact that each event had (strength of dollar, geopolitics, etc.) on the price has been studied and

argued by enough scholars with differing opinions and therefore accurately discerning the relative impact each event

had on the same crude oil price shock is not feasible (Khan, 2017). Hence, this section of the paper will simply state

what the overall environment was at the time of the price shock and all the possible reasons for it.

1973 – Known for the OPEC Embargo

The beginning of the 1973 crash can be traced back to the point when Syria and Egypt decided to attack Israel. This

was followed by another significant action – an OPEC embargo on oil exports to countries that were supporting Israel.

Production numbers thus reduced by 4.4 million barrels per day which corresponded to 7.5% of total global output

(Hamilton, 2011). As one can imagine, such a large shortfall in production led to a large increase in the price of oil,

especially for countries like the US that were supporting Israel during the Yom Kippur War (Smith, 2006).

Another major factor that led to the 1973 price increase was the removal of the Gold Standard in late 1971 which led

to the devaluation of the dollar and hence made dollar denominated crude oil cheaper for the rest of the world

(Varoufakis, 2011). The US economy (no longer as economically influential) became a trade deficit nation (OPEC

were comprised of surplus nations) and was feeling the undue effects of the prolonged Vietnam war. Earlier in 1971,

the OPEC members had signed the Tehran agreement with multiple oil companies which included a tax and an

increased posted price for crude oil. This agreement was reached under the premise of a higher value for the dollar.

The dip in the value of the dollar was an added incentive for OPEC to start the embargo and possibly use the Yom

Kippur War to influence the price of oil.

The early 1970s also saw a decline in the flowrates from the oil fields in the US (due to maturity of the reservoirs) and

a shift in the center of oil from the Gulf of Mexico to the Persian Gulf (Hamilton, 2011). There was great power that

came with being the center of such a strong commodity and thus the US tried to slow the pace at which this shift was

happening by using its influence in the region.

Finally, the Federal Reserve reduced the Fed Funds rate to drive economic activity in the US. This move by the Federal

Reserve indirectly impacted the price of oil as with growth comes an increase in the price of commodities that support

that growth (Kilian, 2008, 2009a, 2009b). These were the main reasons of the oil price shock in 1973 and they were

instrumental in the continual shock that was seen in 1978-79 till the mid-1980s.

1979 to 1986 – War and Economic Slowdown

In 1978-79 there were uprisings in Iran (influenced by the US). Iran was gaining greater influence in the global

landscape and it is thought that geopolitics played a part in causing the unrest in the country (the Shah of Iran fled

during this time). Initially the uprisings were constrained to large public protests but in time it spread to the oil sector.

This led to a reduced production of 4.8 million barrels per day which was approximately 7% of global output

(Hamilton, 2011) and resulted in a spike in oil prices. Saudi Arabia before it became OPEC’s swing producer made

up about a third of this lost production.

Figure 1. Monthly production rates (in million barrels per day) for 5 OPEC members, 1973:M1-2010:M8. Data source:

Energy Information Administration, Monthly Energy Review, Table 11.1a

(http://tonto.eia.doe.gov/merquery/mer_data.asp?table=T11.01a). (Hamilton, 2011)

Just as Iran was recovering its lost production, the Iran-Iraq war began in 1981. This once again caused supply

disruptions which led to a short drastic price increase. Post this, due to prior events such as the embargo and the

resulting slowdown in US growth and global demand for oil, the price of oil slowly dipped from there for the next 5

years. This lower global demand led to an oversupply of oil and hence OPEC members suffered from unexpected

repercussions of the embargo. To further magnify this impact, non-OPEC members’ crude oil were preferred to OPEC

crude oil due to their actions of the previous decade.

During this time, Saudi had officially taken on the role as the swing producer (it had flexibility in its production and

hence balanced any loss or gain in production from another OPEC member state) for OPEC and along with it took the

biggest financial hit from this price shock (half the percentage loss of group’s total share of production (Hamilton,

2011)).

OPEC soon decided to make a geopolitical play and moved to a flexible pricing policy. Shortly after, Saudi Arabia

ramped up its production. As a consequence of these actions the price of oil dropped by more than 50% in a 12-month

period. OPEC members tried to irreversibly damage the production capacity/ growth prospects of the rest of the world

by selling their resource at much lower than the rest of the world’s breakeven costs. What they didn’t expect was that

the rest of the world would become more efficient and thereby survive on these low prices for a long period of time.

Due to technology limitations on most production sites in the world, most countries could not tailor their production

(ramp up or down production) like countries like Saudi Arabia. This had a long-term negative impact as capital

expenditure on exploration for new reserves was heavily reduced and hence long-term proven/developed reserves

reduced day by day.

Another geopolitical side to this rapid increase in production was the heavy blow Iran and the USSR took due to the

drop in prices. A common theory stated is that Saudi Arabia and the US worked side by side on this strategy to take

on their biggest rivals at the time by crippling them economically. Whether this is accurate or not, the results were

visible as it had a very strong negative effect on the strength of Iran and started the eventual downfall of the USSR.

As was done in the previous shock, it is important to take note of the actions of the Fed during this time. As oil is

priced in terms of dollars, these actions and the strength of the dollar (which was rapidly from the late 1970s till 1985)

are very significant. The expected reduction in interest rates to foster growth (and demand for energy) to counter this

drop in crude oil was not possible. It was thus highly apparent in this period that if the US is ever facing high inflation

(>12%) and a large drop in crude oil prices, that the Fed must increase interest rates to reduce rapid inflation growth.

This period resulted in many large geopolitical outcomes where the landscape of power across the world changed

drastically. Additionally, the financial impact resulted in many countries’ foreign reserves depleting significantly. In

1986 the price shock finally reversed as a result of increasing global growth/demand. To quicken this reversal, the

unfortunate Chernobyl disaster in 1986 occurred. Nuclear energy, which was a rising competitor to conventional

energy, took a crippling blow that resulted in an increased demand for conventional energy and hence a price increase.

1998 to 2008 – Asian Crisis, Iraq War and the Financial Crisis

The 1998 to 2008 period was the next time the price of crude oil fluctuated rapidly and for new and different reasons

(i.e. not solely due to war, competing nations etc.). Up until 1998, Asia was seeing expeditious growth and the internet,

where opportunities seemed endless, was taking the world by storm. Later that year, the price of oil dropped by over

50% (relative to the prior year) with the price per barrel dipping to a low of ~$10. This was primarily due to investor

skepticism of the Asian tiger (China, Thailand, South Korea, Malaysia, etc.) growth story (Khan, 2017). A year later,

sentiment reversed and prices rebounded by over 35%. This drastic price change was soon followed by even more

rapid price fluctuations stemming from the end of the dot-com bubble as well the terrorist attacks on the US in 2001

(Kahn, 2017). In response to the resulting economic downturn, the Federal Reserve Bank and other global Central

Banks enacted aggressive fiscal measures helping the global economy and, consequently, oil prices turn around.

It was during these uncertain times where a significant amount of industry consolidation occurred. Some of the most

noteworthy consolidations include Exxon and Mobil, BP and Amaco, Chevron and Texaco, Conoco and Phillips

Petroleum and Totalfina and Elf representing over $300 billion in transaction value. These deals helped the

consolidated companies gain strong efficiencies and significant influence in the marketplace.

Price volatility continued in the early 2000s driven by major global conflicts. The Afghanistan and Iraq war led to 2

million barrels per day being taken off the market while a Venezuelan oil strike compounded the impact with an

incremental 2 million barrels per day decline. Losses were magnified from US dollar weakening which stretched out

for nearly a decade. These multiple events caused significant stress to the global energy system and resulted in a

dramatic increase in the price of oil. Even though the amount of oil that was removed from the overall global supply

was not as large, as previous events discussed, the fear of supply shortages and other stresses to the system caused a

large increase in price.

Crude oil prices continued to climb on the back of growth in Asia. The rising global demand / growth led to crude

prices surpassing $70 a barrel while the Federal Reserve gradually increased the Fed Funds rate to counter inflation.

Additionally, in order to fund lofty budgetary requirements, OPEC members routinely cut production to maintain a

price of over $70 per barrel (Khan, 2017).

The next significant fluctuation in crude oil prices occurred in 2007 and 2008 when the price of oil jumped from $92

to $147 per barrel (primarily due to derivatives trading and speculation) and then back down to below $40 per barrel.

This period’s volatility, and the subsequent crash in crude oil prices the following year, were the result of (Khan,

2017) –

• Financial Crisis of 2008

• Large volume of institutional investment in crude through derivatives (e.g. Futures)

• Falling Value of the US dollar

• Asian oil demand growth

• The rise of National Oil Companies

• Geopolitical issues in the Middle East, Nigeria and Venezuela

• Rising average cost of production of oil due to deep water projects, etc.

• Non-OPEC supply growth

• OPEC production cuts

The aftermath of the financial crisis was a devastating recession. While the recession left much of the world in disarray,

it did serve to change mindsets and philosophies with countries and companies working together to minimize spend,

prioritize efficiency and focus on innovation. The lives of fields in the North Sea and Mexico extended and helped

countries like the UK, Mexico and the US maintain a strong revenue base while minimizing large CAPEX. To further

support a recovery and spur economic growth, the Fed rapidly reduced the Fed Funds rate to encourage borrowing

and spending in the economy.

2014 – The Current Volatile Environment

After the 2008 financial crisis, multiple events occurred that resulted in the rebound of the crude oil price and caused

instability in the sector.

For instance, the US finally managed to economically tap into its large shale formations and domestic oil production

went from over 5 million barrels per day to over 9 million barrels per day. This led to a severe reduction in the amount

of crude that was imported (lowest in over 25 years). As usual, with oil comes gas and hence the amount of natural

gas produced in the US similarly increased by over 35%. Furthermore, large investments were made in refineries in

the US, like the BP Whiting refinery, the Motiva refinery, etc., to process the heavier crude oil from the oil sands in

Canada.

Around this time the unfortunate Fukushima Daiichi nuclear disaster in March 2011 occurred and put a dent in nuclear

energy’s rise just as it did when Chernobyl occurred in the 80s (the month after the Fukushima disaster saw the highest

oil price since June 2008). To add to all these events, the Arab Spring (many OPEC member countries saw large civil

uprisings demanding democracy) occurred and showed a growing discontent in those nations. The protests faded as

they were met by government supported militia, regional/international intervention and military support. These

changes and the instability in the sector led to the price of oil rising from ~$94 a barrel to over a $110 barrel.

The rapid rise in the price of crude oil made multi-billion projects like oil sands, shale oil, ultradeep water exploration

and large-scale LNG plants economically viable.

In 2014, on November 27th, members of OPEC unexpectedly decided to not reduce their overall production as a result

of a weaker global demand. This started a drastic drop in prices.

A key reason for a weaker global demand was that Chinese growth had started to slow down. This was shown by the

reduction in the steel and iron ore demand from China in 2014. Additionally, the world started to invest behind

renewable and nuclear sources. China alone increased its investment in renewable energy to $89.5 billion. Even Saudi

Arabia’s Vision 2030 plan (and many other countries’ plans due to COP21) called for an incredible investment of over

50 GW of Nuclear Power and to diversify itself from being a conventional energy focused economy. As the oil market

reacts significantly to small changes and new pieces of information, the oil prices continued their downward trend.

The Fed Funds rate during this period changed not to spur economic growth and demand but to counter inflation and

keep it below the 2% target level.

Where Saudi Arabia could be profitable at below $20 a barrel, the breakeven cost for shale oil was over $70 a barrel

and for the oil sands significantly higher over $85 a barrel (IHS). It is commonly accepted that OPEC incorrectly

expected, as they did in the 1980s, to gain global market share by making it economically unviable for other countries

to sustain their new sources of production. However, just like in the past, through efficiency initiatives and innovative

technology, processes like refracking (capitalizing on additional production from older shale oil and gas wells by

utilizing new technology), countries managed to reduce their breakeven costs. For instance, shale production

breakeven costs were significantly lowered to sometimes at just over $30 a barrel (Kemp, 2015).

Another reason for the fall in oil prices during this time was that the US dollar had been strengthening quietly and as

crude oil is bought and sold in USD, the more expensive it is, the weaker the demand of the crude oil. From July 2014

to early 2017, the US dollar increased its value relative to other major countries by up to 10% in trade-weighted

nominal terms (Khan, 2017).

As in the past, geopolitics played a significant role in the oil price fluctuation during this time. Iran’s sanctions had

just been removed and so they rapidly increased their production. There was a highly achievable plan to build the

“Shiite Crescent” pipeline which would have directly challenged the current supply of oil to Europe by the Sunni

dominated countries. Just as in the 1980s, it was generally agreed that that the Sunnis were being supported by the

US, while the Shiites (Syria, Iran) were being supported by Russia. As Russia was also slowly regaining a strong

foothold in global politics, it was in the benefit of the US to support the Sunnis. The fall in crude oil prices led to this

pipeline becoming economically unviable for the economies reeling from the effect of the crash of oil prices.

Furthermore, construction of the pipeline would have been severely impacted due to the unrest in Syria, where a large

part of the pipeline was planned to be housed. Finally, Russia and Iran again like in the 1980s, saw a drop in their

foreign reserves and yet again lacked the flexibility in their production to directly match the world demand for crude

oil. This caused their geopolitical influence and the funds to build the pipeline to swiftly diminish.

One of the most publicized (and the final) reasons for the oil price crash was high inventories. Many large ports around

the world had (and still have) multiple oil tankers parked in the water nearby with no demand for the oil they were

carrying. In addition to the weaker global demand, Iraq, Iran and the US’s rapid increase in production led to the

increase of global crude oil inventories (U.S. inventories reached a staggering record highs of 518 million barrels in

March 2017). Such a large level of inventories meant high assets on balance sheets and minimized revenues and

therefore a barrage of suppliers willing to sell their resources at a lower price.

These low crude oil prices, like in the late 1990s and early 2000s, were again instrumental for multiple oil company

consolidations which were headlined by Shell and BG. In addition to this, major oil companies started to buy into

shale (due to the low CAPEX required) through acquisitions that mimic deals such as Exxon and XTO or through

purchasing land with shale reservoirs.

The reasons for the oil price fluctuation in this period were quite similar to previous crude oil price shocks. The next

section, will state links that are now more apparent between these oil shocks that could have provided early warning

signs to countries and different firms to counter or hedge against the damaging effects of an incoming oil price shock.

Figure 2. Chart of West Texas Intermediate (WTI or NYMEX) crude oil prices per barrel back to 1970 (inflation

adjusted). Data source: http://www.macrotrends.net/1369/crude-oil-price-history-chart.

1973 Shock –

Price increase

from supply hit

from OPEC

Embargo

1979 to 86 Shock – Price increase from supply hit from

Iran Uprisings, Iraq-Iran wars and then price crash due

to global growth slowdown and crude oil oversupply 1998 to 2008 Shock – Price decrease

from fear of Asian tigers’ growth story

being false, price increase from growth

story being true and multiple wars,

price decrease due to financial crisis of

2008, heavy institutional investments

into crude oil derivatives

2014 to current Shock – Price decrease

from high global oil inventories due to

overproduction (shale, Iraq and Iran)

and China growth slowdown

http://www.macrotrends.net/1369/crude-oil-price-history-chart

The Web of Links between the Different Crude Oil Price Shocks

As can be seen from the previous section, there are a myriad of reasons for the previous crude oil price shocks.

However, by delving into each one individually to identify the main reasons for the shock, a few commonalities have

appeared. Just like with a ‘Candlestick’ chart in the stock market, a single signal might not necessarily constitute an

upcoming crude oil price shock, however, when a multitude of signals occur in a similar time-period (or if one is

overtly dominant) then they may. Companies should take these signals as warning signs of an upcoming shock and

accordingly hedge their risks.

1. Rise of a Competing Nation/ Loss of OPEC’s Influence

The energy sector and geopolitics are closely tied together. The lack of energy or energy related revenue can cripple

a countries’ growth and development as well as their geopolitical influence. This has been key when looking at how

the US, Russia/ USSR, Saudi Arabia and Iran have impacted the market since the 1970s.

For example, during the 1979-86 era, Iran was starting to succeed and have major influence in the Persian Gulf and

hence was a threat to Saudi Arabia. It is widely accepted that the US, a long-term Saudi Arabia ally, influenced the

protests that began in Iran, causing heavy disruption that included the Shah of Iran fleeing the country, and had

supported Iraq in the Iran-Iraq war. In addition to this, as opposed to reducing the overall production to see a favorable

oil price in the mid-1980s, Saudi Arabia started to overproduce and hence caused a price crash, resulting in significant

damage to Iran and the USSR as both their budgets were heavily based on crude oil revenues. The damage to Saudi

Arabia however was minimized as they had invested in the flexibility of quickly ramping up and down production.

This capability that both Iran and the USSR did not possess was their undoing.

The 1998-2008 time-period was positive for Iran and Russia in terms of growth. However, the sanctions on Iran due

to its nuclear program as well as the 2008 financial crisis caused enough of a negative impact on the two countries

that no other influence was required by the GCC or the US.

Finally, the current day’s crude oil price crash has severely impacted both Russia (as it was gaining significant

geopolitical power through Putin’s actions) and Iran (recently came off sanctions). By the time the overall production

cuts were agreed to by Russia and OPEC to raise the price of oil and minimize the oversupply in the market, the

amount of capital these two countries could employ towards further growth and influence was heavily reduced. For

instance, as mentioned before, the ‘Shiite Crescent’ pipeline was now unlikely to go ahead.

It is highly apparent from the examples above that the clear winners in these have been the US and Saudi Arabia.

Surprisingly, Iran and Russia repeatedly came across the same problems and did not build in the required

flexibility/contingency plans that would have been key to minimizing the downside impact of later shocks.

Another key entity that regularly has large impacts on the crude oil market is OPEC. Understanding the reasoning

behind their decisions is very important to properly hedge a country’s or company’s risk. It is surprising how similar

their decisions have been over the years when comparing different crude oil price shocks.

For instance, OPEC’s decision in 2014 was far from atypical. In fact, it is highly similar to their decision in 1985

where they decided against a production cut to drive down the price of crude oil (below their competitor’s breakeven

costs) as they were gradually losing influence and market share to a growing production from the rest of the world

(mainly the US). Unfortunately for OPEC, just as in the 1980s, their plan did not succeed as the efficiency/ technology

improvements of the rest of the world and shale’s benefits of being low CAPEX and fast to start-up allowed these

competitors to survive the tide until the first production cut was agreed to in late 2016.

As can be seen in most of the major crude oil price shocks, when new countries come to the forefront and start gaining

a larger influence, geopolitical issues arise and the crude oil price is heavily impacted often to benefit the parties that

have that current influence. One of the interesting countries to keep an eye out on is the ever-rising China to see what

actions such as the airstrip in the South China sea and their new Silk Road Project will result in.

2. War or Civil Unrest in Exporting/Importing/Transporting Countries

War and civil unrest in countries where crude oil impacts the bottom line also has a large impact on crude oil prices.

It is important to note that since 2000, even a small change to the total supply/ inventory of crude oil or the growth

expectations of a country (i.e. China in 2014) results in a large impact on the crude oil price. For instance, let us look

at the 1998-2008 time-period. As mentioned before, the unrest that occurred in Venezuela and the war in Afghanistan

and Iraq, resulted in supply disruptions and a crude oil price spike. Similarly, the Arab Spring resulted in supply

disruptions as well as uncertainty in the market due to civil unrest in Libya, Egypt, Iraq, Algeria, Iran, Kuwait, Oman

and Sudan. In both these situations the price of crude oil rapidly rose even though the amount of supply disrupted as

compared to the total global supply was minimal.

Another example of this is the civil unrest in Nigeria (Chevron noted this as a prime reason for its revenue depletion

in the 2015 4th quarter) and Libya which caused supply disruptions. This was one of the core reasons for the rally of

increasing prices of crude oil that started in the spring of 2016. Finally, Turkey’s failed coup caused fear throughout

the industry. Being the bridge between Europe and Asia and responsible for over 3% of global shipments, the

temporary shutdown due to security concerns caused a short stint crude oil price increase.

As one can see from the examples above, civil unrest or war in a major oil importing/exporting/transporting country,

even if the impact is small, could lead to the market over-reacting and having a significant impact on the price of crude

oil.

3. New Technologies/ Alternative Sources of Energy

Like in all other sectors, even in the energy sector, developments in technology have made a large impact and at times

even changed its landscape. For example, as the price of crude oil slowly creeped up after the financial crisis, countries

started investing heavily in Shale deposits and Oil Sands as breakthroughs in technology made it economically viable.

As more projects were taken on, the breakeven cost reduced due to economies of learning. This was discussed in the

previous section and was shown to be highly apparent as at onset of the sharp reduction in the price of crude oil in

2014, the breakeven cost of production of oil from Shale (and now oil sands) reduced enough to be competitive with

conventional methods.

In the non-conventional side of the energy sector, anything new or different tends to initially be expensive or looked

at skeptically. For instance, the two times Nuclear Power has risen rapidly in popularity, unfortunate events in both

Chernobyl and Fukushima casted great doubts and fear on its use. The period post both these events resulted in a

higher demand for conventional sources of energy and hence their prices. In fact, the plans to build nuclear reactors

by RWE npower and E.ON in the UK were cancelled due to the safety concerns after the Fukushima disaster.

At the same time, just as a crisis can impact the price of crude oil, so could success. There have been significant

economies of learning in the renewable energy sector and therefore since the People’s Climate March in 2014 and the

COP21 agreement in 2015, the rush for clean energy has led to large investments by many parties (China, Google,

Tesla, etc.). These investments include research in new technology that have the potential to disrupt; tidal turbines,

next generation biofuels, improved energy storage (fuel cells, solar to liquid fuel, etc.),Thorium nuclear etc. These

new sources of energy, though relatively niche right now, have led to the reduction of the global crude oil demand

even though global energy demands continue to rise.

As one can imagine, any new technology or alternative sources of energy could completely change the energy sector

and hence impact the price of crude oil.

4. Strength of the Dollar and Fed Funds Rate

Two things often discussed when the price of crude oil fluctuates are the strength of the dollar at the time and how the

Fed Funds Rate will change.

When analyzing the past performance of the above two metrics, we see that the strength of the dollar shows a strong

negative correlation to crude oil price during every crude oil price shock. The chart depicting the US dollar index is

below and can be compared to Figure 2 in the previous section-

Figure 3. Chart of the broad price-adjusted U.S. dollar index published by the Federal Reserve Data source:

http://www.macrotrends.net/1329/us-dollar-index-historical-chart.

As can be seen from Figure 2 and 3, the dollar was weakening or strengthening before a movement in the crude oil

price and hence is a great indicator to keep an eye out on (strong negative correlation to the price of crude oil).

However, the movement of the strength of the dollar is not an indicator to be looked at by itself, but it in conjunction

with other indicators.

Prior to the current environment, excluding times of high inflation, the Fed Funds rate movement also correlated

negatively with the movement of the crude oil price. As discussed in the earlier section, this could be seen as a strong

precursor to the 1973 crude oil price movement as well as the movement post the 2007-08 financial crisis. However,

the current low-price environment has put this theory in flux as the shale industry reacts rapidly to Fed Fund rate

movements (traditional methods could take years to construct and start-up as compared to shale which could take as

little as 3 weeks). Since the financial crisis, the rapid rise in production from shale deposits in the US has relied heavily

on debt finance. Therefore now, US production is highly dependent on interest rates and an increase would directly

result in a much higher cost of capital for these companies and a quick reduction in CAPEX for new facilities. As can

be deduced from this, there would be a lower supply of US oil and a resulting increase in the crude oil price (this was

seen in 2016).

From a more global viewpoint, an increasing Fed Funds rate does support the increased production of crude oil outside

the US as a higher valued dollar leads to increased revenues (crude is priced in dollars). However, this is muted as the

market is very sensitive to small increases in supply or inventories and if news of an increase in foreign supply hit the

market, the resulting fall in the price of crude oil would wipe out the increased revenues.

So as to delve into this further, let us look at the current environment. The Fed has recently started to increase the

interest rates as there has been 33 straight quarters of growth in the US economy and bottomed out interest rates are

no longer necessary. Based on past trends, interest rates could continue to rise above 2% up to 2019 and cheap interest

rate loans and low bond coupon payments that the shale industry relies on will start to dissipate. Currently within the

shale industry, many coupon payments and loan interest rates are at 8-10%. An increase of more than 1.5% above the

rates prevalent prior to the 2014 crude oil price crash could lead to an increase of over 15% in interest expenses.

According to the Bank of International Settlements, debt in the oil and gas sector rose by over $1.5 trillion from 2006

to 2014. Due to the large amount of debt that has been issued, interest expenses on average are 5-20% of revenue. The

variation can be seen when comparing a larger firm like EOG Resources/ Pioneer Natural Resources with a smaller,

yet still a multibillion dollar, firm like Continental Resources/ Whiting Petroleum. Where the larger firms have reduced

their CAPEX, and have no major interest payment concerns as the Fed funds rate increase, the smaller firms that have

leveraged too much have big concerns (in 2016 Whiting had an interest expense that was >43% of its revenue).

The amount the annual interest rate expense would increase due to a rate hike cannot be covered by the existing cash

balance for both Continental Resources or Whiting Petroleum (this doesn’t include the credit spread increase as ~25%

of B3 and lower rated firms by Moody’s are Oil & Gas firms). As for EOG and Pioneer Natural Resources, they can

cover this increase 30 times over. This therefore is a strong indication that more consolidation or resource disposals

will occur as time goes by while the Fed increases the Funds rate (if the crude oil prices stay relatively similar). In

addition to this, the credit revolvers that all these firms employ will also be more expensive as they are tied to the

LIBOR rate which follows the Fed Funds rate closely.

The large cap players however will also be in some trouble. As stated before, the breakeven cost in some of the best

areas to drill have radically reduced to just over $30 a barrel. This was possible due to efficiency increases as well as

the large discounts (sometimes greater than 15%) from suppliers and service contractors (Gopinath and Nair, 2017).

As these larger firms have been nursed back to health due to increasing prices, the industry now expects the suppliers

and service contractors to start pulling their discounts to get a larger piece of the pie. This would put these larger

players in some trouble as they have the potential to lose up to $1.6 a barrel due to the discounts being pulled (Gopinath

and Nair, 2017). If they are producing at just over $30 a barrel, this increase results in more than 5% of their revenue

being lost to additional expenses.

If there is any doubt on the impact that low oil prices and high liabilities have had on the industry, it should be noted

that per news outlets such as CNBC, over 100 companies in the industry have filed for bankruptcies since the 2014

crash started. A point to focus on as well is a decrease in new debt that is being issued since 2014 that is resulting in

an increased pressure for additional equity investments. According to PLS’ Capitalize, the trend for refinanced debt

or new bond issuance has steadily decreased each year from 2014 due to the variable and uncertain environment (new

debt issuance reduced from 2014 to 2015 by >7% and 2015 to 2016 by >5%).

For these firms to continue to maintain a healthy cash balance, CAPEX must reduce. The unique problem with that

for shale producing companies is that the rate of production of oil from shale deposits depletes by greater than 50%

after the first year. Therefore, CAPEX can’t be reduced too much else the revenues for those firms that are utilized to

pay off existing obligations will start to fall just as fast.

5. Others

Finally, there are a few more things to keep a look out on based on past crude oil shocks. For instance, when the crude

oil price falls such as in the 1980s there is a long-term impact when it comes to reduction of CAPEX. This was a

significant part of the increasing crude oil price in the 1990s and is possibly what is reducing part of the supply glut

today. According to Wood Mackenzie little over 1 out of 20 barrels produced in 2016 were replaced by new discoveries

(Holter, 2016). However, this future constricted supply problem can be solved by developments of shale deposits

internationally (large deposits in Russia, China, etc.).

Additionally, when crude oil prices rise, rapid increase in CAPEX could gradually lead to a supply glut and thus a

resulting fall in prices. This can be seen in the natural gas market when looking at companies who invested billions

on LNG projects when the price of LNG was ~3 times today’s price and hence are now expecting lower returns on

those projects not only due to those reduced prices but also due to an upcoming oversupply of LNG globally.

In addition to the multiple indicators discussed above, it is also important to keep an eye out on the general economy.

An economic crisis or boom would have a large impact on the price of crude oil. Equally, policy changes (in particular

the US) have a similar potential as construction of new US refineries, the construction of new pipelines (Keystone

XL) and tax reforms for the US middle class could result in growth in the world’s largest economy and hence a large

increase in demand of crude oil.

Strategic Recommendations

The opportunities in the Oil and Gas sector can be summarized by the following quote in Shakespeare’s play, The

Tragedy of Julius Caesar, where Brutus speaks to his brother-in-law Cassius –

‘There is a tide in the affairs of men. Which, taken at the flood, leads on to fortune; Omitted, all the voyage of their

life is bound in shallows and in miseries. On such a full sea are we now afloat, and we must take the current when it

serves, or lose our ventures.’

Background and Existing Structures

Over the last couple of decades, the unicorns and behemoths of the technology sector have been celebrated as the

companies with the fastest revenue growth. However, there are many firms in the Oil & Gas sector who performed

just as well, such as World Fuel Services who realized the fastest Fortune 500 revenue growth (till the 2014 crude oil

price shock) over the previous decade. However, the quote is just as true for the sector when it comes to losing your

ventures where the same firm saw a ~30% decline in revenues between 2015 and 2016.

As can be seen in the previous section, history often repeats itself in the sector when a crude oil price shock is

imminent. Just like in the technology sector, it is only a few decisions that helps separate the success of Google as

compared to Yahoo!. In the oil & gas sector, that similar difference can be seen for example between Devon Energy

and Halcon Resources.

The oil & gas sector is very sensitive to small shifts in demand and supply. When the market is thriving and prices are

climbing, a large number of companies in the sector aim for fast growth while ignoring cost increases. British

Petroleum is a company that had followed such an approach (at least in terms of cost increases). The result of doing

so was that its ranking in the Forbes Global 2000 fell from a top 50 company in 2014 to 359 in 2016. During the same

time period Exxon Mobil was able to successfully maintain its ranking as one of the top 10 on the list (Gensler, 2016).

Companies who have managed their debt-equity ratio well, integrated downstream efficiently (e.g. make up margins

at the refinery due to cheaper feedstock) and kept their breakeven costs in check prior to 2014 were able to make the

most out of the shock. Exxon Mobil and Shell were able to acquire Interoil and British Gas respectively. As stated in

the previous sections, consolidation is an avenue for future growth and firms who managed their balance sheet well

have historically been able to come out on top after the market recovered from a price slump.

The more global, technology advances and fast paced the world gets, the more the existing system will change. If the

2014 crude oil price shock is to show anything, it is that as the environment rapidly changes, oil & gas companies

need to make adequate strategic and financial decisions for their long-term health and growth.

Strategic Steps

While most crude oil price shock impacts cannot be hedged completely and require a firm to be efficient and

opportunistic to maximize its prospects during the downturn, there are a few steps that have been successfully utilized

in the past. This section will go over a few of those strategic steps that companies can take to minimize the downside

risk of a crude oil price shock. In addition to the 3 steps below, there are multiple other strategic hedges that firms can

utilize such as strategic joint-ventures, decentralization and utilizing/ investing in new technology (e.g. Bechtel’s past

initiative to have a contract with Conoco Phillips for its cascade technology allowed it to dominate the LNG EPC

sphere globally)

1. Keep Costs Low

The most important thing for firms to do in this current environment is to continue to focus on reducing costs.

Studies on the methodology and best practices utilized to drastically reduce the breakeven costs in the best

companies in Shale and Oil Sands should be conducted. These findings can be key to improving the efficiencies

within existing large-scale production processes if a lean methodology/ six sigma is used. Technology like ‘Zipper

Fracking’ where the stress fields are altered through the placement of stages to maximize recovery is an example of

that. This is one form of technology that has the potential to be modified to be utilized in traditional large-scale

drilling (to minimize the requirement for EOR during the later stages in the project).

With large shale deposits around the world and a more efficient production process, a higher crude oil price will

invite an increase in new drilling globally and thus an increased oil supply. Thus, an increased price might be short

lived as it might be met with a rapidly increasing supply as it was earlier in the decade.

In the event of a large increase in demand that is not met with a similar increase in supply, having a conservative yet

agile approach to growth will allow firms to generate a large cash reserves that could be utilized in the event of a

future downturn to consolidate or purchase distressed assets off firms who didn’t strategize well.

2. Invest in Adequate Strategic and Financial Hedges

Another methodology of limiting the downside effects of a price shock are financial and strategic hedges. These can

be achieved through a multitude of ways –

(1) Integrating or diversifying efficiently to limit the downside during hard times like Saudi Arabia is doing

in its ‘Saudi Vision 2030’. Another example is how some supermajors minimized the downside impact

of the current shock by maximizing margins from downstream processes due to cheaper feedstock.

(2) Investing in production flexibility (like Saudi Arabia) to allow a company to react instantly to a large

demand increase (or reduction) for energy resources. This requires a large upfront fixed cost but has

proved its worth (Saudi Arabia in the 1980s over the USSR and Iran as well as Saudi Arabia in the

current environment over Russia and Iran). With the upcoming expected CAPEX shortfall, this

capability will again prove to be immensely fruitful.

(3) Long-term investments in certain high upside regions which currently have civil unrest. For example, if

the risk of Iran’s likelihood of sanctions can be hedged, the upside of massive infrastructure projects or

low breakeven cost oil concessions is worth a long-term investment.

(4) Constantly tracking key indicators of a relevant economy’s health and assessing the likelihood of any

upcoming monetary policy, fiscal policy or laws allows firms to make decisions to swiftly maximize or

minimize any benefits/ downsides that would follow.

(5) Investing in the adequate financial hedges during favorable times (highly lucrative after 2014 crude oil

price shock for the Mexican government).

3. Invest in Alternative Sources of Energy/ Energy Storage

COP21, the People’s Climate March and investments in clean energy by countries and firms like China and Google should

be an indication of the necessity to ensure that firms adequately diversify and invest in technology early enough to maximize

benefits.

Many companies of sizeable scale have adopted this philosophy. For instance, Total has instituted a plan that requires a fifth

of its asset base to be low-carbon technologies and acquired a battery manufacturer to get into the rapidly growing space of

energy storage. Another example is the recent join research project initiated by Exxon Mobil’s and Synthetic Genomics that

has led to a breakthrough in biofuels. The research discovered an advanced cell engineering technology that would double the

oil content derived from algae.

A common method for companies trying to diversify and get into this space is to create JVs where they work with/

fund/ invest in firms with these technology or research capabilities. For instance, Shell has used their existing expertise

and cash flow to either fund new developments or lower project costs and risk by taking an ownership stake (Shell is

teaming up with Ionity to roll out electric charging points at their fuel stations in Europe due to rising sales of electric

cars)

Thus, as the world’s energy mix changes due to regulation or a country’s/ company’s policy, it is highly evident that

investing and diversifying early could help minimize the downsides of any crude oil price shock caused by new

technology.

Conclusion

As can be seen from this paper, there are many avenues for additional research. One avenue which was too technical

for the scope of this paper is to study the daily price movements since 1970 through a dynamic model to see what

reasons caused each significant price movement (e.g. >$1 a barrel in a day). This could lead to a methodology to

understand the price impact that new news creates based past data.

The oil & gas sector is an exciting space. It is a sector that could easily ‘make or break you’. Understanding its inner

workings, the multiple moving parts and the indicators that effect it are critical when making strategic decisions.

Therefore, to truly have long sustained growth, keeping an eye on the multiple indicators stated in this study and taking

the best strategic and financial steps should lead to reaping all the benefits of striking sweet and sour black gold.

Bibliography

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