The current crude oil price regime derives in the main, from market fundamentals: a weak global demand and a massive increase in supply. That increase in supply over the past decade came from unconventional resources predominantly in the United States (shale) and Canada (oil sands); during that period, the petroleum group, Organization of the Petroleum Exporting Countries (OPEC), maintained output within a very narrow band.

The group’s decision late last year ― driven primarily by Saudi Arabia, Kuwait, Qatar and United Arab Emirates ― not to reduce output levels in spite of the massive supply overhang, spurred what was termed in the media, a “sheik-versus-shale” turf war.

If that decision was aimed at forcing production cutbacks among the higher-cost (unconventional) producers, then OPEC, with much lower production breakeven costs (US$10 – US$30 per barrel) than United States (US$55/bbl – US$85/bbl) and Canadian (US$65/bbl – US$110/bbl) producers, has been able to do just that: Of the seven key production regions in the United States, for example, output for the month of March 2015 fell or remained unchanged in all but two, according to the Energy Information Administration. The rig count data as compiled by Baker Hughes is even more informative. The full rig report shows a 43% decline in U.S. rig count from three months ago. Even the newly-employed operational efficiencies are not expected to countervail the effects of such steep decline rates. Production reports and rig counts are, respectively, lagging and leading indicators of production trend, not withstanding imperfections in the latter.

Credit Squeeze

Many of these unconventional or tight oil producers had borrowed substantially to fund their operations and analysts estimate that operators had spent as much as US$1.50 for every US$1.00 earned. Credit facilities were often based on companies’ proved oil reserves as well as average crude oil prices. These facilities are typically evaluated in April and October, but with about a 50% drop in oil prices over the past nine months, there are concerns that this month of April, some lenders may not be amenable to credit renewals; especially when the United States Federal Reserve is mulling over rate increases.

Some of these companies were victims of their own success; for example, some spent massively in exploration and made significant discoveries but needed to find extra funding for the development phase ― quite a challenge in a low oil price regime. Without adequate funding for their operations, these companies may quickly go out of business and there are indications that a handful of companies are so disposed. Such companies may therefore be amenable to deals in order to stay in business.

Oil Supply

Prospects of any sustained oil price rebound are being blighted by continued additions to the supply overhang. Saudi Arabia, the world’s largest oil exporter, recently raised her oil output, and Libya, with the largest oil reserves in Africa, recently announced a modus vivendi among rival military factions, turning on their erstwhile offline oil taps.

However, the most significant addition to the glut would be from Iran, which recently reached a framework agreement that would lift sanctions on her oil and gas activity. Analysts believe the country is capable of increasing oil output by as much as 800,000 barrels per day within three months of lifting of sanctions; and the Energy Information Administration has reported that if a final deal is reached, it could reduce its 2016 oil price outlook by US$5/bbl – US$15/bbl. There are also reports of large oil volumes stowed away by Iran; for example, according to Reuters,

“Sanctions have cut Iran’s oil exports to about 1.1 million barrels per day from 2.5 million bpd in 2012. The OPEC nation is keeping about 30 million barrels of crude on a fleet of tankers ready to be shipped when allowed, into a market already flooded with supply.”

While a final agreement is yet to be reached, the effectiveness of the current sanctions regime on Iran would be severely eroded if China and Russia were to pull out, an increasingly likely outcome should the June deadline not be met. With the recent visit to China by an Iranian delegation for oil talks, the stage may be set for a sanctions-breaking accord.

Mergers and Acquisitions

The initial response by oil companies to the recent slump in oil prices included staff layoffs, reduction in capital expenditure and assets divestment among others. These however constitute a first-tier response and are, in the main, short-term fixes. When low oil price regimes become protracted, second-tier or more strategic measures would be necessary for many companies if they are to remain in business. Consolidation is one such measure. The 1990s ― after oil prices slumped to as low as US$10/bbl ― saw mergers and acquisitions (M&A) such as BP and Amoco, Exxon and Mobil, Chevron and Texaco among others.

While current market conditions ― low oil prices, debt-burdened operators, opportunities to increase competitive advantages ― lend themselves to consolidation, Evaluate Energy reports that M&A value for Q1 2015 tumbled by 79% from that of Q1 2014 and 85% from the average value per quarter since 2009. The attribution is to a classic market stalemate, where buyers want to buy on the cheap while sellers balk at what they consider unreasonable valuations due to low oil prices. This may be possible in part because many oil and gas companies’ share prices are yet to fully reflect the  current slump in oil prices. According to Evaluate Energy, the companies most suitably positioned at present to make opportunistic acquisitions are, in descending rank order, Petronas (PNADF), Royal Dutch Shell (RDS-A), ExxonMobil (XOM), Chevron (CVX), BP, PetroChina (PTR), ENI (E), Total (TOT), Lukoil (LUKOY) and Statoil (STO).

Royal Dutch Shell this week made a bid to acquire BG Group for US$70 billion. As Economist notes, BG’s share price had fallen by 30% since last summer (in sympathy with oil prices) making the company a tempting target for acquisition. Shell, which has battled falling output and has had challenges to its Australian gas development, may find positive synergies in the acquisition; though the company’s investors have expressed reservations about adequate returns due to such high premium being paid for BG. In addition, regulators may insist on substantial divestment before approving the deal while BG investors may face significant capital gains taxes.

ExxonMobil, which has had challenges with reserves addition, last month revealed plans to ramp up output from shale fields in the United States to help fund its global expansion and with its financial muscle, may find a window in the current oil price regime.

PetroChina already has joint venture projects with Shell and has just overtaken ExxonMobil as the world’s largest company by market capitalization. According to World Oil (04/09/2015):

“Exxon’s capitalization was $352.6 billion through Wednesday, compared with PetroChina’s $352.8 billion as of 1:36 p.m. on Thursday in Shanghai. The Chinese company’s A shares surged about 61% the past year, versus Exxon’s 14% drop. PetroChina was larger by value most recently at the close of trading on June 25, 2010, data compiled by Bloomberg show.”

Oil services companies are usually early victims of falling oil prices and as such, candidates for M&A. Although the deal is awaiting regulatory approval, oil services companies Baker Hughes (BHI) and Halliburton (HAL) shareholders have agreed on a merger of the two companies.

With oil prices expected to rebound very slowly, many analysts expect significant M&A activities in the near term, especially in the wake of the Shell-BG deal; what the scope would be, remains to be seen.