As oil prices hit rock bottom at the international market, Demola Ojo takes a look indigenous operators’ massive exposure to the financial sector and concludes that dire times lay ahead if urgent steps are not taken quickly to save the sector from imminent collapse
The COVID-19 outbreak has profound implications for many sectors, and the oil and gas industry is no exception. In fact, the prevailing mood in the oil and gas industry is one of anxiety and concern.
Even before the pandemic disrupted financial markets, upended supply chains, and crushed consumer demand across the global economy, oil-industry leaders were not optimistic about 2020. The industry was already on high alert, and executives expressed pessimism across all geographies and price points.
But fast-forward a few months, and the oil and gas outlook has gotten dramatically and suddenly bleaker with the continuous shutdown of key economic centres in Europe, America, and South-east Asia on the outbreak of the novel Coronavirus.
Indeed, the industry is now on red alert as demand has plummeted and loans obligations of players in the industry remained unpaid.
This unforeseeable humanitarian and financial crises have rendered previously planned strategies for 2020 redundant, leaving oil and gas businesses exposed or rudderless as their leaders confront a disorienting future and vulnerable workers worried.
For many in the oil and gas industry, the glass is half empty. The mood among respondents to our executive survey is sober across geographies and price points, and the pockets of optimism seen last year have steadily evaporated.
The survey of the industry indicates that players may have to shut down if the global lockdown persists and government does nothing to help operators.
To this end there is need for the industry to be rewired, especially as it is the mainstay of the Nigerian economy as the major revenue earner for government. In other words, there should be a conscious policy intervention, especially on the issue of debt overhang arising from the global energy crisis and its impact on indigenous Nigerian upstream oil and gas players.
Covid-19 Flashpoint for Disruptions in Oil Market
COVID-19 could spur the biggest economic contraction since World War II, hitting every sector from finance to manufacturing and to hospitality. Yet energy, because of its supply and demand sensitive nature, is particularly vulnerable.
The average market capitalisation of oil and gas companies on the Nigerian Stock Exchange dropped significantly before the outbreak of COVID-19 and has witnessed much steeper decline than that of the overall stock market in the first quarter of 2020.
Particularly, the bane of the downstream section of the local industry has often been linked to failure of the fiscal authorities to come up with market-driven reforms such as the implementation of Petroleum Industry Governance Bill (PIGB), removal of subsidies on petroleum resources, revamp of local refineries and adoption of flexible exchange rate system.
For the upstream segment, the general crash in global economic growth has contained demand just as competition among oil reliant-economies has flooded the market with products leading to falling prices.
Initially, when prices started to plunge at the end of January 2020, EIA had forecast that Brent crude oil prices (the equivalent of Nigeria’s Bonny Light) would average $43/barrel in 2020, down from an average of $64/barrel in 2019. The forecast had also gone on to predict that oil will average $37/barrel during the second quarter and then rise to $42/barrel during the second half of the year, but all that projections have fallen flat as Brent crude, the equivalent of Nigeria’s Bonny Light, currently trades at $12 per barrel, well below industry expectations, forecast, planning and production costs
Beyond this, there is also a horde of unsold inventory given the shutdown of most global economies on the heels of the COVID-19 pandemic. Given this scenario, liquidity of most Indigenous oil concerns has already been severe as a result of the loss of material cash flow due to the global energy crisis occasioned by the coronavirus pandemic.
This disruption has a dire consequence for the local players in Nigeria’s upstream and downstream oil and gas industry, who are fighting to maintain operations and margins
Loan Exposure to Nigerian Banks
Nigeria’s banking sector is the second largest in sub-Saharan Africa behind South Africa. Total assets were worth over N40 trillion in September 2019. But with crash in oil prices in the wake of COVID-19, small and mid-sized Nigerian banks may be constrained to rebuild capital levels going forward as it would be difficult for businesses to repay loans, including oil companies.
Presently, many indigenous oil and gas producers in Nigeria are struggling to stay afloat, as prices of their products have fallen below production costs. This is just as they are failing to meet their debt obligations to deposit money banks. The result is that their portion of non-performing loans in the banking industry is threatening the soundness of the nation’s banking sector.
The oil and gas sector represented about 30 per cent of Nigerian banks’ gross loans at end-3Q19. Accordingly, loan quality is highly correlated to oil prices, as seen during previous oil price shocks in 2008-2009 and 2015-2016. Though impaired loans have decreased since 2017 due to rising oil prices as well as recoveries and write-offs, the current shock could lead to a significant increase. Any closures of oil fields due to a collapse in global oil demand would exacerbate the impact.
The biggest problem local upstream operators face to today is the apparent mismatch between their loan exposure and the significantly dwindled revenues due to the Coronavirus pandemic. With sub $20 per barrel prices for crude, these companies are in dire straits. Average cost of production per barrel in Nigeria is about $30 per barrel due largely to high cost of operation and security related expenses that are peculiar to the Nigerian environment. The burden of managing community restiveness has been practically left to these operators alone.
The Trans Forcados Pipelines and the Nembe Creek Trunkline through which most of these operators evacuate their crude are often the target of militant attacks leading to incessant force majeures. However, the loan agreements with these indigenous players were structured in a manner that does not provide for force majeure. Interests on these loans continue to mount regardless of the reality on ground. A chief executive of one of the indigenous companies who spoke on the condition of anonymity said banks needed to be more sensitive to the plight of their customers. He maintained that moratorium on principal alone would not be sufficient as the operators simply cannot pay the interests for now.
He called out the banks for striving to make profit in an economy where the companies they are funding are going under. According to him “banks need to put their skin in the game and realise that this is a symbiotic business. All stakeholders must partake in the shared losses at this time so that when the rebound occurs, we equally share in it.’’
As at the beginning of the year, tier-one banks were estimated to have had an oil exposure of over N4.33 trillion, meaning banks could be forced to make trillions in loan loss provisions and impairments as bonny light oil prices have fallen from around $66 at the start of the year to as low $12 per barrel.
The impact of current situation would lead to weaker earnings in 2020 if the oil loans, especially the upstream oil loans are fully provided for. In other words, banks may have to declare losses at the end of the year despite modest results released in Q1.
Reflecting its expectation that banks will face material pressures from the weaker operating environment in the coming months, Fitch recently downgraded three Nigerian banks’ Long-Term Issuer Default Ratings (IDRs) to ‘B’ from ‘B+’ and placed all 10 Nigerian banks’ Viability Ratings and IDRs on Rating Watch Negative. It explained that the resilience of banks’ asset quality, profitability and capital during the economic downturn would influence, among other considerations, how it resolves the Rating Watches.
Meanwhile, reports have it that commercial banks are set to begin the recovery of N6.125 trillion borrowed by oil firms to braze themselves amidst the sector’s recapitalisation fears. The banks have reportedly issued correspondences to oil firms, marginal filed operators and downstream operators, as debts in the sector, according to a 2018 CBN financial stability report, showed that N1.235 trillion had been added to the sector’s debt profile since 2016 when it stood at N4.89 trillion.
“Banks are beginning to takeover collateral tied to the loans,” says a management staff of one the marginal field oil firms as banks followed up on the correspondence sent to his firm.
Mitigating Inherent Risks to the Economy Upstream Oil Industry to Banks
The current demand and price crisis in the oil and gas sector, which started in February 2020, has gone on for almost three months now with a lot of upstream oil industry players already defaulting. Consequently, since global demand is not expected to increase significantly in the near term, crude oil prices will remain low throughout this second quarter, putting Nigeria banks at risk to oil companies’ exposure once again.
Most commentators on the topic say mitigation efforts on the inherent risks to the economy should look at what was done or not done during the 2015 – 2017 price crash since the same scenario is playing out once more, noting that non-involvement of government in the oil industry exposure of 2015 – 2017 had huge impact on both the companies and the economy.
They canvassed that a moratorium on debt repayments should be worked out between banks and oil-producing companies in Nigeria to cushion the effects.
On the part of oil majors, they should adopt leverage and hedging strategies against lower prices, which would determine their chances of survival as well as the size of the hit to their lenders.
The determining factor, according some analysts, would be whether or not producers hedged when oil was above $60 and that a number of more conservatively managed firms would be dragged into restructuring discussions with their lenders if the current level is maintained beyond a couple of months.
“Depending on how long this thing lasts, high-cost producers could suffer. If it lasts for a long period, then they will be in trouble because most of them need the oil price to reach above $40 per barrel to break even,” one of them said.
They recommend that oil companies should appeal to their lenders that the current operating environment is a case of force majeure, which could buy them time.
They strongly advocate the involvement of both fiscal and monetary authorities to mitigate and contain the crisis in the oil sector.
They however, noted that that volatility could bring its own opportunities for those who have avoided excessive borrowing.
“The oil price crash creates openings for cash-rich and under-leveraged players to pick up ‘quality producing or near-producing assets at a significantly lower price’ than previously.”
Policy Intervention to Stave-Off Collapse of Indigenous Upstream Players
The government cannot sit on the sidelines and watch the banks and the oil operators wade through the current turmoil in the oil market. The fiscal and monetary authorities should evaluate their non-involvement in the 2015 – 2017 crisis and come out with relevant policies to sustain the oil companies throughout this coronavirus-induced price crash as well as stave off a recurrence in the future.
Monetary Policy Option
The Central Bank of Nigeria (CBN) through the Bankers Committee should work out a moratorium on debt repayments by local oil-producing companies as long as the coronavirus lockdown lasts. This would create a win-win position for both the banks and the oil companies without adversely affecting their operations. There should also be a restructuring plan for the companies to exit the bad-loans overhang, thereby creating buffers for recovery as the global economy gradually opens up.
While banks focus on negotiating with local oil companies to restructure their loans in line with current realities, it is expected that all banks will migrate a significant portion of oil companies’ exposure due within the next 12 months from stage 1 to stage 2. That should be based on the IFRS 9 requirement on expected credit loss because the probability of default variable has increased and the small companies would most likely default.
These should be codified into a guiding policy by the CBN, which could include regulations on single obligor limits for oil industry operators.
Fiscal Policy Option
The fiscal policy option should include bail-outs or tax concessions to indigenous oil producers in order to aid recovery and help advance the government’s push for local content and a connection of the upstream oil sector with the local economy going forward. The fiscal option should also include removal of subsidy so that the local downstream section to be market driven.
In the United States, President Donald Trump has already hinted a bailout for U.S. oil companies that have been hard hit by a recent historic dive in crude oil prices.
Trump tweeted his support for the industry after crude oil futures prices dove into negative territory on Monday for the first time ever, a signal that the drop in demand from the pandemic-shuttered economies around the globe had outstripped the production cuts from OPEC, Russia and the U.S. companies that have moved to rapidly idle oilfield operations. The Nigerian government should consider this as well.