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The oil and gas industry is caught firmly within the current global economic crisis. At year-end the crude oil price has fallen to around USD 40 per barrel for Dated Brent compared to a high of USD 147 during 2008 as demand for crude has fallen. On the back of four years of increasing oil prices, costs in the industry have risen significantly. However, the recent oil price collapse has not yet resulted in a similar fall in costs. The credit crisis has resulted in downward pressure on share prices as investors seek ways to free up liquidity and has seen the banking market close for new business as the banks struggle for their own survival.
 Financial markets
The collapse of the sub-prime loan markets has caused losses to the banking industry of an estimated USD 1.5 thousand billion. The losses that have been incurred have been compounded by additional losses incurred on various banking derivative products created on the back of the sub-prime mortgages and traded between the banks in the range of six to eight times. The liquidity that has been removed from the financial markets through the collapse of the sub-prime loan markets has caused a follow on collapse of the world economy.
This decade had seen worldwide GDP growth at an average of almost 4.5 percent per annum with strong contributions from the Middle East and developing Asia. The collapse of the Western markets has eroded the demand for the manufactured goods upon which this growth was based. 2009 is seeing Western countries enter into recession and the World Bank is forecasting that China’s growth, which has averaged almost 10 percent per annum this decade, will reduce to 6.5 per cent per annum reducing the demand for raw materials.
This decline in growth has had a significant impact upon the oil markets.
Crude oil
The price of crude oil has risen steadily over the past four years culminating in a record high of USD 147 per barrel for Dated Brent in July 2008. Following the collapse of the world’s financial markets the oil price has fallen to around USD 40 per barrel for Dated Brent.
The oil price is primarily a product of the economic principle of supply and demand but it is also affected by other influences. Oil demand grew by 9.3 million barrels of oil per day from 2000 to 2007 and oil production for 2008 amounted to approximately 85.5 million barrels of oil per day. Whilst oil supply increased during this period to meet the demand, concerns that the world’s oil production was approaching the maximum levels at which the industry could produce and process the product created a market environment where future oil prices were traded at a higher level than the price on the spot market. Forward oil prices were further increased by financial speculation on the rising oil prices.
The lower demand for crude oil has created downward pressure on the crude oil price and the fall in price has been exacerbated by the departure of the financial speculation within the pricing model.
OPEC, which accounts for approximately 40 percent of the world’s crude oil production, has announced its intention to reduce its oil production by around 4.2 million barrels of oil per day with the intention of controlling supply to keep the oil price within a range of USD 50 to USD 70 per barrel.
Costs
The high commodity prices achieved over recent years have lead to cost increases in addition to the normal rates of inflation. The increased revenues generated on the back of the higher commodity prices have lead to an increase in the level of investment in oil field developments and exploration by the oil industry. But this investment has been through an oil service sector that had been lacking in investment in its own infrastructure over the previous decades resulting in increased competition amongst oil companies for the limited resources available, both equipment and manpower. The competition to secure drilling rigs for future work commitments or field developments has forced companies to secure the rigs several years in advance at today’s inflated day rates. Similarly, a lack of skilled people has caused contract day rates to increase significantly.
The lower revenue streams generated on the back of the lower commodity prices and the lack of equity and debt funding has led companies to cut back on investment activities, particularly projects that are not sustainable at today’s oil prices. This lack of investment will free up the competitive pressure on the service sector and the costs will begin to decrease but it will take time and costs will not return to the levels that they were at the last time that crude oil traded at its current level.
The higher revenues generated from the higher commodity prices have also been acted upon by host governments with the introduction of increased tax rates or requests to renegotiate the underlying Production Sharing Contract (PSC).
Equity markets
The collapse of the world’s financial markets and the ensuing recessionary pressures has had a significant impact upon the world’s equity markets. The Nasdaq OMXS index has fallen 45 percent since its high in June 2008 and the Nasdaq has fallen 50 percent in the same period. The sustained strong economic growth over the past three decades has seen a strong confidence in investments in equity markets with investors willing to take highly leveraged positions in the certainty that gains on shares would outweigh the cost of financing. The current economic crisis has led to uncertainty in these share investments because the full extent of the economic downturn has not yet been felt in the world markets and there is a concern for the level of losses that remain to be revealed. This uncertainty has caused investors to sell shares to repay their debt positions and to transfer their investments into more traditional investment safe havens of government guaranteed bonds or gold backed assets. Investors will need to feel that they fully understand a company’s assets and future earnings before they begin to invest in shares again.
In addition to a lack of investor confidence in investing in the stock exchange, there is also a lack of funding available for the bond market. Bonds are one of the alternatives for funding in the oil and gas industry but this source of financing has disappeared in the current economic environment creating significant refinancing risk for companies that have existing bonds maturing in the near term.
Bank finance
The collapse of the world banking system has been well documented in the international press. The direct losses incurred as a result of the sub-prime mortgages has been calculated at around USD 1.5 thousand billion but with the repackaging and onselling of derivative products based upon the sub-prime mortgages the losses are many times this amount. Some banks have gone bankrupt as a result of the losses, such as the highly publicised failure of Lehman Brothers, but other banks have been saved from this outcome by either direct investment by governments or by their promise of guaranteed funds or financial products.
The banking market is dependent upon the ability to lend and borrow funds to each other within the banking system as liquidity needs dictate. Following the losses detailed above, the banks have experienced a severe liquidity crisis and interbank lending has been substantially reduced as banks either hesitate to assume the counter party risk associated with lending to another bank or hold the funds themselves to protect their own liquidity position.
With one or two notable exceptions, bank lending to the independent sector of the oil and gas industry has ceased. Banks are limiting their business to servicing existing client relationships and the cost of financing is significantly higher than it was twelve months ago.
Lack of investment
The current world economic situation has hit companies’ liquidity twofold, firstly through a lack of funding from the capital markets and secondly from the generation of lower operating cash flow. The lack of access to cash flow is resulting in a reduction in investment in the industry. Marginal developments are being deferred or cancelled and exploration expenditure is being cut. The medium to long term effect of this cut in investment is that it reinforces the boom or bust cyclical nature of this industry. Over time the recessionary pressures that are affecting the world economies will ease. Demand for products will generate growth but the ability to provide energy for this growth will be severely impacted by the lack of investment now. New projects that were scheduled to come on stream over the next few years will be delayed, if developed at all, limiting the ability to meet production needs as demand grows. The ensuing short supply of crude oil production and infrastructure could force oil prices back up to peak 2008 levels, if not beyond.
Lundin Petroleum
Lundin Petroleum currently has two loan facilities totaling USD one billion. The secured revolving borrowing base facility of USD 850 million is syndicated to 19 international banks and the unsecured corporate facility of USD 150 million is shared by three banks. The banks providing the loan facilities are obligated to fund the loans should Lundin Petroleum decide to draw them.
Lundin Petroleum’s existing financing, which was put in place at the end of 2007, along with the operating cash flow generated from its operations, is sufficient to fund its capital programme through the coming years at the current oil price levels. The capital programme includes exploration expenditure in addition to the capital expenditure necessary to maintain the forecast production profiles because it is important that Lundin Petroleum not only continues through these difficult economic times but also is in a position to grow as the world economies begin to pick up. Lundin Petroleum continues to closely monitor developments in the economic areas that affect the business and is well placed to adapt to market changes as they may present themselves over the coming year.
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