Credit crisis threatens small firms

A contraction of the global economy would have a significant impact on oil development in North Africa.

Scientists hope that algae and other microscopic organisms could one day be used to make biofuels.

As the world financial system teeters on the brink of collapse, the energy industry has been a lone bright spot, feeding off record oil prices to undertake the largest expansion in oil, gas and alternative energy capacity in history. Day rates for drilling rigs and engineers have soared, oil companies are swimming in profits and farmers around the world are reaping a harvest of record prices for their crops, which can be turned into ethanol and biodiesel to supplement crude production.

But a severe tightening of credit and the ensuing contraction of the global economy would be a death knell for many of the world's marginal energy producers, ranging from exploratory oil wells in the Sahara desert to research firms seeking to develop algae as a competitive source of biodiesel, analysts say. For state oil firms like the Abu Dhabi National Oil Company and the international oil majors, the effects will be difficult to detect since they can fund projects out of the huge cash reserves they have amassed in recent years from record-high oil prices.

But smaller firms are much more vulnerable. Robin Mills, the petroleum economics manager at Emirates National Oil Company in Dubai, said the credit crunch would have a significant impact on oil development projects in North Africa, especially Algeria and Egypt, where small companies have taken exploration blocks in obscure corners of the desert. "There's definitely an effect on the projects funded by the smaller companies," he said, noting that many of those companies raised their operating capital by selling off large slices of equity in reserves they hoped to discover.

"It's become very difficult for them to get funding at all," he said. In the current environment, initial public offerings (IPO) and bond sales were now more difficult for all oil companies, said John Vautrain, a senior vice president at Purvin and Gertz, an oil consultancy. Mr Vautrain said that financing of large projects would likely be affected by the decline in the bond market, since oil companies often issued bonds to cover their long-term debt obligations on a project after they had completed construction.

Independent alternative energy companies rushing to put up wind farms and solar thermal plants were also likely to get hit hard by the shortage of easy capital, Mr Mills said, Many such firms in North America relied on venture capital and represented an uncertain investment for risk-averse banks, he said. Over the longer term, however, a forecast decline in the oil price represents a more potent threat to energy companies than the credit crunch, since it makes high-cost oil production less attractive and diminishes the incentive for investing in alternative energy producers.

The price fall is led by shrinking demand, a result of the slowing of the global economy. Each month, demand forecasts for oil have been lowered as the economic malaise deepens. Opec officials have vowed to support the price, which has been on a downwards slump since July, and today's marginal production costs can probably hold oil prices above US$70 a barrel. But Mr Vautrain said he doubted that Opec's control over supplies could keep the price at $100 amid a worldwide economic recession.

"That price level could never be defended," he said. "It was based on a market mentality that doesn't exist today." If prices fell substantially, biofuels producers would be the first to close up shop, analysts said. "I think the biofuels guys, that's yesterday's news," Mr Vautrain said. "That whole programme was ill-conceived." The production of biofuels from staples such as corn and sugar cane has been widely blamed for increasing worldwide food prices, and governments are now less likely to support the industry with subsidies amid a fall in oil prices and complaints that it is worsening conditions for the world's poorest.

Wallace Tyner, a professor of agricultural economics at Purdue University in Indiana, estimates that without government subsidies, oil prices would have to hold at about $100 to make ethanol production from corn competitive with fossil fuels. "It will be an industry that will stay small and absorb agricultural surpluses," Mr Vautrain said. If oil prices continue their retreat, next up on the chopping block will be the so-called "strippers", the companies that focus on squeezing additional oil out of depleted reservoirs. In Texas, the benchmark oil price for "strippers" to make a profit used to be about $20, Mr Vautrain said, but costs had increased markedly since then.

When oil prices collapsed in 1986, many of the strip wells were capped permanently. "If the crude price collapses, you'll get the same impact," Mr Vautrain said. Far more worrying for its potential impact on world oil supply, however, is the effect that falling prices could have on efforts to develop crude from costly non-conventional sources, including the oil sands projects in Canada and heavy oil conversion in Venezuela.

According to Opec estimates, by 2030 these crude sources will produce 7.5 million barrels per day, making up almost seven per cent of the total supply. Last week, Christophe de Margerie, the chief executive of Total, the French oil major which is financing an oil sands project in Alberta, warned that the venture would be under threat if oil fell below $90 a barrel. Some estimates have put the break-even price point at $85 a barrel for the most expensive oil sands projects.

But those estimates are based in part on continued high prices for oil services workers and equipment, which would doubtless fall amid a sustained economic downturn. Plus, much of the costs of oil sands conversion came from the high cost of energy, which would also fall in line with the decline in crude prices, Mr Vautrain said. If the current crisis continues unabated, and crude prices fall substantially, it will shake up the world energy industry. Small companies will be bought up or go bankrupt and major expansion projects will be put on hold.

But a major oil company would not sink billions of dollars into a project on the assumption that abnormally high prices would continue, Mr Mills said. "I don't think these guys are making investment decisions based on $90 a barrel," he said. [e-mail]