Peak Oil- but for whom?

Hubbert’s Peak Oil theory was famous amongst previous generations of oilmen because, apart from positing that there was only a finite amount of recoverable crude oil and that, therefore, there was a real risk of “running out”, it fostered the conviction that the future value of oil in the ground was likely to be worth more than oil for immediate production. This meant that the hunt for reserves and reserve replacement ratios of over 100% were fundamental to an O&G company’s raison d’etre.

However, while one can argue logically that the world’s hydrocarbon resources are ultimately finite, recent experience of development of new reserves (such as US “tight” oil), the continuing relatively low level of nominal oil prices, and the unveiling of a number of new scenarios for supply vs. demand, are now causing concerns that perhaps not all those reserves will be worth as much as has long been assumed.

This shift in opinion raises a number of important questions:

– For example, should a company, or a country (such as Saudi Arabia), seek to pump oil at maximum capacity in order to monetize its reserves, but thereby run the risk of driving down at least spot prices?

– What if rational carbon-pricing policies are implemented, resulting in taxes or levies that currently are largely absent from many jurisdictions?

– Will the long-assumed steady increase in demand for oil and oil products from rising populations in the developing world, seeking to emulate the living standards and use of resources in the developed world, be overwhelmed by changes in technology or more efficient forms of existing alternatives such a wind or solar?

– Is natural gas production more defensible in terms of future demand and use than crude oil?

If it turns out that demand will gradually taper off and drop below projected production levels, and that prices will remain low in both nominal and real terms, the implications both for the industry and for the global economy will be profound.

Producers will have to change their focus from a “customized” approach to one that amounts to systematized “manufacturing”- similar to what is already visible in the operations of the most efficient US “shale oil” producers- in which repetitive, low-cost solutions will be essential; while “petro-states” will have to take meaningful steps to diversify their economies rather than assume that “eventually” prices will rebound because demand “always” ultimately outstrips supply. This is also likely to engender more standardization across all levels of the industry, as the need to focus on costs will become inexorable.

All this requires a change in the way in which one analyzes any O&G related risk, because assumptions that even 5 years ago would have seemed almost axiomatic (e.g., reserve replacement ratios should be above 100%, or that over time the price curve usually has a contango) may no longer be so. Of course, the history of the industry is also littered with the carcasses of those who made the wrong call!

At Awbury, our approach is to avoid “assuming” that something is so or will be so unless we can also analyze the probability of the key assumptions no longer proving to be valid- and what the consequences of that may be in the context of the overall risk.

As one of our colleagues states: “The Stone Age did not come to an end because the World ran out of stones…” The Hydrocarbon Age seems unlikely to end because of “Peak Oil”.

The Awbury Team

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Rendez-Vous? Ah! Those were the days, my friend…

The Awbury Team attended the latest MCRV; and, fortunately, survived the experience relatively unscathed, relying upon robust constitutions, careful risk selection (quality, not quantity [of alcohol]); and not much sleep.

As has been the case in recent years, one could detect that same yearning for the days when the market was a gentler, more forgiving place, in which the phrase “technical price” was not uttered through gritted teeth and in which “it cannot go any lower” was not met with a rolling of the eyes and a knowing smile at the naiveté of the speaker.

The recent Aon Benfield market outlook noted, “…ample capacity remains available to support current growth aspirations…” and “reinsurance capital is at peak levels”. Consider also the following statistics derived from the same Aon Benfield report: From 2008 to 2015, overall reinsurer capital increased by 70% (sic) to USD 585BN; yet, during the comparable period, cessions to non-affiliates from US primary insurers only increased by 18% to USD 80BN. There has been a recent modest uptick in cessions as a percentage for premia, but they remain at relatively lower levels. It is, therefore, not surprising that rates have remained under downward pressure, even if the discussions on the topic at MCRV were not as robust as some would have wished and there was little consensus on “what happens next”. At some point, reserve releases will no longer be available to flatter Combined Ratios and pricing in many segments will reach (if it has not already) “walk away” levels.

Given all that is so, any improvement in available returns is likely to come from a sustainable increase in demand from primaries in commoditized areas such as NatCAT (perhaps through deeper market penetration into currently underserved geographic areas), “hot” new segments such as “Cyber” (but be careful what you wish for!), or from writing business that is not price sensitive, but is based upon the needs of a client who finds its difficult, if not impossible, to find the appropriate cover elsewhere.

At Awbury, we have continued our work on broadening the portfolio of products that we can tailor for our clients, as we not only adapt the results of our own research, but also respond to enquiries from our expanding client base.

In consequence, we believe that there is growing interest in areas such as the much-maligned O&G sector, and in infrastructure, as well as in extensions to the concept of capital relief- and not just in the banking sector- with more rationality in allocating capital to the side of the balance sheet where it can earn the most efficient and better risk-adjusted return. It no longer makes sense (not that it ever did!) to emphasize one side of the balance sheet over the other, or to assume that an investment exposure has to be taken on the asset side.

So, as summer fades in the northern hemisphere, and thoughts inevitably turn to “next year”, it is worth re-considering how to meet and exceed your budget targets, and where to seek profitable new business.

The Awbury Team

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Plugged & Abandoned…

As if low prices for crude oil and natural gas were not causing enough stress on many US upstream E&P businesses (as evidenced by the burgeoning number of restructurings and Chapter 11 bankruptcy filings), their executives are now faced with the potential need to provide significantly increased levels of “Plug & Abandonment” (P&A) collateral to satisfy enhanced regulatory requirements being imposed by the Bureau of Ocean Energy Management (BOEM) on companies operating (or which have interests in) offshore leases and fields in the Gulf of Mexico (GoM) and elsewhere in US territorial waters, also referred to as the Offshore Continental Shelf (OCS).

A P&A obligation is simply an example of an Asset Retirement Obligation (ARO), whereby any operator, or prospective operator, of an O&G field in the GoM has to provide assurance to the BOEM that, as and when any well or field comes to the end of its useful life and has to be de-commissioned, there will be sufficient resources available to carry out the necessary work to the required standard; with the collateral providing assurance that, should the operator default, the costs of de-commissioning will not fall upon the public purse. Providing P&A collateral is, thus, an essential component in managing any US “offshore” E&P business.

The issue is that providing such P&A assurance has traditionally been done with bank letters of credit (LoCs) or surety bonds. In addition, many companies were able to obtain a significant level of exemption from the BOEM (called “waivers”) allowing them to self-insure such obligations because of their financial capacity. However, to provide bank LoCs and surety bonds most companies have had to eat into their banking facilities and/or post collateral against the provision of a bond, which is both a constraint on their financial resources and economically inefficient.

Now the world has changed, and, for some, drastically.

The new regime, which came into effect on September 12th, means that the BOEM will no longer grant waivers; nor will it allow self-insurance of P&A obligations beyond 10% of any company’s Net Tangible Worth (NTW). In addition, it is going to use more rigorous financial formulae and qualitative assessments to determine a company’s ability to self-insure, and will no longer take into account the joint and several (J&S) nature of obligations in respect of offshore leases, but in many cases look at an operator’s capacity on a stand-alone basis. And, just to make its point, it is imposing a tight timeframe for compliance- with staged requirements over the next year.

All of this, not surprisingly, is causing some consternation amongst the companies affected, as they receive letters from the BOEM setting out the extent (if any) to which they will be permitted to self-insure. We anticipate that many company executives will suffer “sticker shock.”

However, the BOEM has also publicly stated that it will now, at a Regional Director’s discretion, accept a much broader range of collateral to provide the required “financial assurance”, including policies of insurance. Through its insurance companies, Awbury specializes in providing its clients with solutions to complex credit, financial and economic issues, such as the ones many now face in the P&A realm. Not only that, but, because we undertake a comprehensive analysis of all the risks involved, including an Obligor’s credit capacity, we are able to provide those solutions in ways which do not unnecessarily tie up its bank lines or working capital; allowing management to focus on more productive uses of a company’s resources. We are, therefore, able to help those facing new or increased P&A requirements to manage them effectively and promptly.

So, if the letter you receive from the BOEM causes a sharp intake of breath, you should give us a call!

The Awbury Team

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