IOCs

What about the integrated oil majors, which have long been staple features of many institutional and retail investment portfolios? They include ExxonMobil and Chevron in the US, Shell, TotalEnergies, BP, plus arguably Equinor and Eni in Europe. Although their downstream (refining and marketing) arms provide some degree of internal hedge, they are also very vulnerable as their value is inherently geared towards higher oil prices. All else equal, a healthy mix of oil and gas projects in an IOC portfolio might provide some helpful risk mitigation, but as Edition 8 explained back in May, the gas market is also heading for a material oversupply. 2026 is starting to look like it could be a year of reckoning for IOCs. 

In their defense, the IOC business model has been tested many times before and found to be reasonably robust. A focus on mega-projects helps to keep breakeven prices under control, while profitable trading arms and large balance sheets backed by broad banking syndicates have helped to withstand volatility.

This time, however, with both oil and gas markets heading south, IOCs are sailing into very choppy waters. Besides the obvious hit to upstream project economics, it is also much harder to make big commodity trading profits when prices fall and stay lower for longer. Trading desks thrive on volatility, but also higher prices. Previous periods of low prices have often driven industry consolidation, with financially stronger players snapping up weaker counterparts. Existing industry challenges have already driven plenty of that in recent years, but we may well see it accelerate further. But this is no guarantee of future success - and big company integration is no walk in the park. Earlier this year, continuous speculation forced Shell to explicitly confirm that it was not looking to take over its ailing counterpart BP. Lower prices will likely bring such speculation back.

IOCs are essentially a careful balance of cycling capital into big, high-return assets, efficient project management, divestment of mature or lower-return assets, controlling leverage and maintaining attractive and reliable dividend payments. They have learned to be efficient financial machines, with excess cash increasingly used to buy back shares in support of share prices. If oil prices head below $50/bbl for an extended period, IOC balance sheets will inevitably come under mounting pressure. Their investability has always been underpinned by steadily growing demand, but they have never been tested in an environment where that demand growth starts permanently reversing. Buybacks would be the first casualty, removing an important share price support. But buybacks are a nice-to-have, while dividends are a need-to-have. Dividends, in fact, have become the IOCs’ raison d’etre. They must protect them at all costs, even if this means maxing out leverage – but in a weak oil price environment the limits of leverage also shrink. If these payouts come into question, then the whole IOC financial model starts to unravel. We are certainly not there yet, but the next few years look very likely to test its limits.

E&P companies

If life will get tougher for IOCs, then the independent E&P companies face an even bigger challenge, being inherently less hedged and lacking the portfolio diversity and financial strength to withstand prolonged slumps. E&Ps are the smallest fish in a very big ocean, competing with everyone from IOCs to major oil nations like Saudi Arabia and Russia. Size matters: the bigger you are, the better your chances of survival. When it comes to a fight over a shrinking pie, the bigger boys are going to be ruthless. As the oil price tide goes out, for E&Ps the focus can quickly switch from investability to basic bankability. In other words, at lower prices will their banks (or other creditors) still expect to get their money back? If not, semi-annual facility redeterminations and other structural risk mechanisms can quickly close the net. A prolonged slump also effectively removes the potential to use financial derivatives to manage price risk, as existing hedge contracts roll off. 

The US and Canada still have vibrant independent E&P sectors, while Norway has the strongest in Europe. The UK sector is in apparently terminal decline, consolidating into a dwindling number of viable operators struggling against a harsh fiscal regime (under both Conservative and Labour governments) eking out what tax revenues it still can. New offshore UK projects face the dual economic challenge of weak oil prices and a high marginal tax rate, which may well continue indefinitely. That’s about as unappealing for investors as you can get.

But even in the US, the much-feted shale revolution, pioneered by that country’s E&P sector, has always struggled to actually be profitable. Most US shale companies currently break even in the $60-65 range. In other words, they’re just about treading water now, before prices fall further. It is true that over 2014-16, when OPEC+ countries last tried the Abandon strategy, US shale producers demonstrated an impressive ability to find efficiencies and reduce their breakevens, thanks to technical and operational innovation. But the trickier issue of profitability was never really solved.

It’s also true that North America still enjoys vast untapped oil and gas resources. However, ten years on from the previous OPEC showdown, many analysts believe the easier acreage has been exploited, leaving behind mainly the harder, deeper, more expensive unconventional resources. Even if shale producers can find yet more efficiencies, it’s very tough to make money consistently when you are chasing prices lower. One exception might possibly be US gas-focused players, given the prospect for higher domestic gas prices there as less associated gas gets produced and an increasing proportion gets exported as LNG. But as noted before, that prospect already looks well priced in.

Won’t low prices help rebalance the market?

The old oil market truism reminds us that “lower prices are the cure for lower prices”. The price slump will certainly hit investment levels hard, so to some extent this is true. Absent investment in new wells or other recovery enhancements, oil reservoirs naturally decline by 5-8% every year. In fact, nearly 90% of oil and gas expenditure reportedly goes to replacing existing supply. In theory, then, investment only needs to drop by 10% to allow supply to eventually fall back in line with demand, allowing prices to normalise and enabling producers to carry on as before.

However, that logic has always prevailed against the backdrop of steadily rising demand. With demand decelerating and heading for terminal decline in only 5 years, possibly even less, that logic is now living on borrowed time. In a perfectly friendly and rational market, everyone might cut back a bit, leaving enough for others to get by. But the reality will be an even more aggressive competition for share of a shrinking market – a hazardous environment for all but those with the lowest breakevens.

The big picture

Finally, in the oil market it’s all too easy to get buried in the detail. If we zoom out to look at the last quarter century, we can see that in real terms (adjusting for inflation) prices have actually been trending downward since the peak right before the financial crisis of 2008, as per this helpful chart from seasoned energy expert John Kemp.