One of the first questions that arises when approaching the February 2018 MCS pre-seen document is: what industry are we dealing with here? In this particular case, you are working as a senior financial manager who liaises with the Finance Operations Shared Service Centre (FOSSC) in a major global oil company. Much of the pre-seen material focuses on the nature of the operations within the FOSSC, while the financial statements pertain primarily to the Nortan oil company as a whole. Naturally, one might wonder where one should then focus when it comes to performing an industry analysis.
The biggest clue comes in the form of the FOSSC’s vision, mission statement and strategy on page 9 of the pre-seen. As you can see in the screenshots below, the FOSSC is committed to understanding and responding to the evolving needs of the Nortan group as a whole, and making proposals as to ways in which Nortan can increase revenues and/or reduce costs. It is for this reason that it is prudent to familiarise yourself with the broader oil industry before sitting the exam in February. And it is with that in mind that we introduce you to a few key points and insights from our full Industry Analysis below…
The price of oil is notoriously volatile, and the second half of the 20th century was characterised by huge variability. Much of this can be attributed to the founding of OPEC around the middle of the century. We will discuss that dynamic in more detail in the full analysis. For now, we’ll focus more narrowly on the last 5 years. As you can see in the graph below, the global oil price has fallen substantially since around 2013, hitting a low-point near the middle of 2016. Since then and throughout 2017 it has shown moderate signs of recovery. This significant drop in prices was precipitated by 3 main factors. Firstly, there was a surge in the amount of natural gas and oil being successfully extracted from shale sources, particularly in the US and Canada, through the extended use of hydraulic fracturing techniques (more commonly known as “fracking”). This put downward pressure on global prices. At the same time, China’s economic growth began to slow, reducing relative demand and creating a surplus in global supplies. Finally, OPEC responded uncharacteristically to this increased competition from North America by flooding the market with oil, in an effort to undercut the newly profitable shale production in the US. In response, the shale producers in the US managed to continue cutting costs and making the fracking process ever more efficient. This resulted in a downward price spiral as OPEC redoubled their efforts to undermine US shale producers.
OPEC finally returned to their historical trend of responding to price drops by radically reducing supply, and implemented a new quota agreement amongst member nations in September 2016. The agreement entailed a total reduction in output of 1 million barrels per day across all nations. Since the quota was implemented, oil prices have shown signs of recovery through 2017. Whether that recovery continues depends on several factors—among them whether or not all OPEC members continue to comply with the quota agreement, and by how much US shale production expands at the same time. Other factors include the medium term economic plans of Saudi Arabia, which we discuss in more detail in the full analysis.
Costs and Drilling Methods
One of the key metrics in the oil industry is “per barrel costs”. Different regions tend to have diverse per barrel costs, based on a number of factors. Perhaps the most important components are capital expenditure and production costs. Oil that it is relatively close to the earth’s surface tends to involve much lower capital and production costs, as it is easier to reach and so is less capital and labour intensive. Those regions where oil is most accessible in this respect tend to be middle eastern countries like Saudi Arabia, Iran and Iraq, where vast reserves sit close to the earth’s surface. As you can see in the graph below, per barrel costs vary widely across nations. However, it is not only geophysical factors that influence per barrel costs. Tax regimes and political regulations/barriers can also put upward pressure on per barrel costs. Venezuela, for example, has vast and relatively accessible oil reserves. However, the dire political and economic circumstances there have created an environment in which oil production has become much costlier than one would expect.
When it comes to actually extracting oil, there are two common structures used: land rigs and sea rigs/platforms. The cost differential is significant. A typical land rig costs in the region of $25 million. Shale land rigs are in fact cheaper, averaging around $20 million. Sea platforms, by contrast, typically cost a whopping $650 million dollars. Unsurprisingly, sea rigs can only be justified financially in cases where vast reserves of oil are discovered below the sea bed. There are also greater environmental risks associated with sea drilling, as was evidenced by BP’s Deepwater Horizon oil spill in 2010. That is why deep-sea oil drilling tends to only be carried out by the so-called “Supermajor” companies, or major national oil companies, who can afford to make such huge capital investments…
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Don't forget to check out our other great free MCS February 2018 article here for more great insights ahead of your exam