Oil has seen a spectacular fall to record low prices even as the largest oil producers have agreed on production cuts in a bid to stabilize the market. The dynamics are relatively easy to understand – a global oversupply coupled with a decrease in demand further crippled by the effects of COVID-19 on energy needs. But the value of oil is not just determined by its physical use but more importantly by the liquidity behind it. It is a business predicated on credit through the use of structuring revolving around pre-payments, open credit terms and credit sleeves. COVID-19 has not just brought oil pricing to its lowest in years but it has more critically wiped credit out of the oil market. We look at the effects of $20 barrels of oil on the entire lifecycle of the market from exploration to downstream trading.
Exploration: Picking-up the Slack on Joint Venture Issues
Oil in Asia is typically extracted by means of a joint collaboration between a local entity with extraction rights and a foreign oil producer with technical and financial ability. When prices dip, there is an inherent tension between the objectives of the local government that expects minimum commitments towards the objectives of extraction and the considerations of the concession holder in delaying production till a time that oil is more profitable. This in turns puts pressure on the joint venture partners with obligations to each other to approve work programmes and honour cash calls under their Joint Operating Agreements (JOAs). It is not uncommon in such circumstances for one party to be reluctant to perform its obligations, operationally or financially, leaving its joint venture partner with difficult decisions to make on options such as forfeiture or step-in rights.
FPSO Construction: Purple Patch to Delayed Deliveries
Floating, production, storage and offloading units (FPSOs) have been undergoing a purple patch with FPSO construction and operator companies noting an uptick in business. These units, whether conversions or newbuilds currently being built in North Asia will inevitably face renegotiations for postponements or cancellations. Shipbuilding construction is a high capital business and involves advance payments made by buyers who at times like these would be faced with the task of walking that fine tightrope between negotiating a delayed delivery while not being perceived as repudiating their contracts with the yards. Yards may be unwilling to delay or cancel contracts and may look to forfeiting deposits while buyers may turn to desperately triggering their refund guarantees prematurely to get access to that all-important liquidity. This scenario played out at the time of the global crash of 2008 and the key take away is that a negotiation can be game of chess with each party waiting for the other to make a wrong move.
Trading: The Effects of the Credit Collapse
Trading is probably where the most damage will be inflicted. Apart from quality and quantity issues in the oil business, non-performance risk is always prevalent with price drops and parties are likely to obscure non-performance with a host of other issues surrounding port closures and force majeure declarations.
Non-performance for economic reasons comes dressed up in different forms but the most common would be an assertion that no contract has been agreed either because contracts were not signed or key terms were missing. The very basics of contract law are typically tested and the court cases on these issues will show that sometimes even the basics may not be that straightforward to apply in factual scenarios where contractual terms are informal and are constantly evolving during its execution.
In the trading business, one will also need to navigate the minefield of termination events from failing to nominate a vessel, opening a letter of credit to complying with the shipment date; a wrong step in these crucial areas may been inadvertently trigger a termination event.
Credit is also an inherent part of the trading business and this raises issues for the oil industry. Some small oil trading companies rely on third parties to open letters of credit (LC) on their behalf creating a new contractual matrix between a seller who on the one hand has negotiated a contract with its buyer but on the other hand has to pursue the buyer’s “LC Agent” under its signed contract. Other oil traders without sufficient banking lines, engage in credit sleeving whereby they leverage on the physical assets of a larger supplier. There is no lack of creative structures that companies in the oil business deploy but they have a common objective in leveraging for liquidity.
As credit gets tightened, highly leveraged oil companies will stagger – there will be difficulties in open LCs and credit terms and sleeves would be withdrawn. Without liquidity, the smooth flow of oil between many inter-dependant companies will slow down and there is likely to be a domino effect.
On a more positive note, Chinese private refineries known as “teapots” (described as such because of their size compared to the large state owned oil refiners) may have some respite as lower prices are likely to give it a lifeline in its domestic market although that may be short-lived if demand stays muted.
Lending: The Scramble for Security
With credit concerns reverberating in the markets, security enforcement has been at the forefront of credit providers. In such times, tracking and getting access to the physical asset is paramount and may be easier said than done. BLs and BDNs need to be assessed and in a market where oil is easily commingled, identifying your product may prove challenging and different lenders may end up scrambling to lay competing claims on the same product stored in offshore or onshore storage tanks.
Security enforcement also brings into acute focus deficiencies in pledges, guarantees and charges over assets and companies in different jurisdictions. Further details of issues to consider when enforcing security can be obtained from our webinar at this link.
Storage: The Contango King
With oil futures now higher than current spot prices, storage, like it was in 2008 has now become king. With storage and tanker rates at record highs. Facilities owners are bullish and may attempt to revisit less profitable leases to free up committed storage space for more lucrative offers. It has simply got to a point that there isn’t sufficient storage in the market which puts downward pressure on exploration/production efforts and trading as excess capacity still remains in the market.
With demand likely to remain low in the foreseeable future, parties in the oil business must be cautious about a domino effect brought by the micro and macro forces affecting oil prices.
Nimble feet will be key in sidestepping any potential downfall.
