Why we should worry about falling global oil prices

As a country aspiring to become an oil and gas producer, Kenya should be worried when global oil prices drop below $80 per barrel.

Two months ago I wrote regarding implications of falling global oil prices when they had just pierced the $100 per barrel level going downwards. Falling global oil prices negatively impact upstream investments.

READ: Oil prices below $100 will discourage exploration in high-risk virgin frontiers

We cannot now pretend that it is going to be business as usual in respect of upstream oil and gas investments here in Kenya. And we had better start managing and downsizing our expectations.

I am not a doomsayer, but most of the times history backs me up. I recall the 1997/1998 East Asia financial crisis that triggered a sudden drop in oil prices from about $22 to just above $10 per barrel. The major oil companies were caught flat footed with their oil reserves and stocks suddenly depreciated, resulting in downgraded shareholder value.

This crisis forced major corporate restructuring and mergers. Exxon merged with Mobil; Chevron with Texaco; BP with Amoco; Total with ELF and Fina among others. It was time to cut and spread costs while disposing of marginal assets. This is when the independents emerged to buy the cheap marginal assets.

Luckily, the Opec came in to save the market with the famous “$22-28 per barrel formula”. If oil prices fell to $22, Opec would cut production to strengthen prices. If oil prices reached $28, production would be increased to reduce prices.

This formula was expected to yield an average $25 per barrel and it protected both the producers and consumers.

The formula worked well until about 2004 when the new era of commodity speculators arrived. Supply/demand fundamentals were thrown overboard as speculation pushed oil prices upwards above their true values. Prices eventually hit levels above $100 which is where they have been until two months ago.

High prices prompted increased investments in more expensive and marginal frontiers. New technologies emerged, producing even more oil. Production from these investments is now arriving in global markets creating a glut. It is during this era of high prices that East Africa became an attractive destination for oil and gas explorers.

Now it is a different picture. The oil and gas reserves sitting in the corporate balance sheets have in the last two months lost about 25 per cent of their values. The upstream investors are already undertaking measures to limit imminent financial damage.

The “peacetime” CEOs will likely be replaced with “austerity” hatchet CEOs to rationalise assets and restructure operations to conserve fast diminishing cash flows.

If oil over-supply and low prices persist, upstream investments across the world will be downsized, postponed or cancelled. Marginal assets will be up for sale while farm-out options will be used to spread costs and risks. Marginal exploration blocks will most likely be surrendered back to licensing authorities.

With reduced oil prices, more volumes of oil discoveries will be required to meet commercial thresholds. We should not be surprised if other less ambitious commercialisation options emerge. Such options may include local refining of crude oil, if oil export infrastructure proves too expensive for such low prices.

Like their global counterparts, we should not be surprised if investors in Kenya soon start to react to dwindling cash flow threats. This may lead to revised investment and work plans. Kenya would experience reduced FDI as overseas shareholders re-prioritise investments. The local content aspirants are likely to be disappointed as investors mull over extent of “keeper” operations.

Another likely casualty could be the CSR programmes.

Shall oil prices remain depressed for long? The D-Day is next week on November 27, when Opec meets to discuss the ongoing oil supply/price issues.

However, Opec is no longer the body with shared interests, as individual members now have differing challenges and plans. Many observers do not expect the meeting to materially reverse what is already happening.

Even if prices resurrect, a number of permanent investor decisions will already have been made. Investments are not a “start-stop” game and far-reaching decisions being made now will be difficult to reverse. However, oil supply/demand/prices/investments are cyclic features with a habit of reversing roughly every five years. We are just exiting one such good cycle – good for investors and producers.

In Kenya the government will need to start managing stakeholder expectations, especially for the local communities. It may also need to be receptive to possibility of having to give investors workable incentives and flexibilities that can allow them to continue with operations to some level of commercial conclusion.

In the meantime, consumers are enjoying the spoils of reduced global oil prices. They are soon likely to ignore fuel efficiencies and conservation as they rev up more kilometres, with increased carbon dioxide emissions. However, overall inflation will go down.

As for the balance of payments, any reduction in upstream FDI inflows would likely be offset by reduced dollar spending on oil imports.

Mr Wachira is director Petroleum Focus Consultants
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