Predictions of a 2016 recovery in the exploration and production (E&P) sector became increasingly rare after 2015 ended with a thud as oil prices sank below USD 40/bbl.
The industry consensus now is that oil and gas prices are going lower for longer, and activity in 2016 will be lower than in 2015, said Ethan Phillips, a leader in the oil and gas practice at Bain & Co. “We are coming around to the notion that when the industry does come back it will look different.”
Oil prices now are no more predictable than they were in December when they unexpectedly slid from around USD 50/bbl to around USD 35/bbl. For many companies that spent last year struggling to eke out a profit at USD 50/bbl in high-cost plays, from deepwater development to shale, that pushed the break-even point beyond reach.
In the coming years, production growth is expected largely from low-cost producers in the Middle East, led by Saudi Arabia, which has stuck with its plan to regain market share, even if that means keeping oil prices low. A spike in tensions between Iran and Saudi Arabia and its allies in early January was a reminder of the political risk associated with the region. But bad market news from China snuffed an oil market rally by showing its appetite for hydrocarbons this year likely will be limited.
While US producers proved surprisingly resilient in 2015—with new platforms in the Gulf of Mexico pushing up the total US annual output—that does not appear sustainable. Lower prices have led to steep reductions in reserve estimates in high-cost plays, increasing pressure from investors and lenders to deal with the problems created by dwindling cash flows. And the cost per barrel in deepwater plays is delaying many projects there.
Investment bankers and private equity investors once eager to put money into unconventional E&P have turned their attention to profiting from distressed E&P deals.
“A few of the things that were kind of propping revenues and activity levels are playing out,” said Karr Ingham, consulting economist for the Texas Alliance of Energy Producers, adding, “It is increasingly apparent that activity levels will drop by more than they are now.”
More Casualties
Another year of lower prices and deep E&P budget reductions are forcing more rounds of layoffs, pushing estimates of the jobs lost as high as 250,000 worldwide, with more to come. Job offers for petroleum engineering graduates have been sinking as the numbers hitting the job market remain at record levels. Drilling rigs and pressure pumping trucks used for fracturing are being stored away for a day when they will be needed again.
“This year it is new territory. We have not seen a period during which the fracturing industry fleet has shrunk” so fast, said Richard Spears, vice president of Spears and Associates, which provides consulting services to the worldwide petroleum equipment and service industry. The firm is estimating about one-quarter of that capacity will disappear. Capacity is being removed part by part as drilling rigs and pressure pumping trucks are cannibalized by owners trying to keep other equipment working at deeply discounted rates.
Many companies in that business will be gone. Spears predicts at least 12 pressure pumping companies of the 50 it tracks will be out of business when the market begins to recover. It expects a 25% reduction in pressure pumping capacity, bringing supply in line with demand, allowing the market to begin to recover no later than 2017.
That is an optimistic view, with others predicting the oil and gas industry to recover no earlier than 2018. OPEC has forecast oil prices to average USD 70/bbl by 2020, but Spears and others expect oil prices to reach that level sooner, in part because of the severe cuts in the industry now.
“As people read this in February 2016 it may feel like the worst month ever, but in that moment are the seeds of recovery sown,” Spears said. “Companies are so full of despair, but what they are doing will lead to better times,” eliminating surplus supplies of oil and equipment.
Stressing
Bankruptcy filings during the last 3 months of 2015 reached levels not seen during the global recession of 2008–2009, and the numbers are expected to rise this year.
“At least nine US oil and gas companies, accounting for more than USD 2 billion in debt, have filed for bankruptcy so far in the fourth quarter,” according to a report from the Federal Reserve Bank of Dallas titled, OPEC Tips Crude Oil Markets Over the Cliff.This year, the financial pressures on E&P companies will rise. A chart from the report showed the sharp decline in E&P spending while failures are rising. Companies are trying to live within the limits of their cash flow as they face increasingly tough credit reviews from lenders and investors.“Those of us with debt in our businesses are doing everything we can to help the bank to not call the loan,” Spears said. “We are trying to hold on to the debt we have got. It is hard to imagine asking a bank for added capital. Right now they are looking at the upstream business with a jaundiced eye.”
Companies that depended on borrowed money to grow faster than their cash flow might allow must now reduce costs enough to generate the cash needed to continue paying their bills and satisfy creditors. Not all can survive the test. Some will become corporate “zombies lacking the cash flow or access to capital to continue operations through 2016, if current price levels persist,” said Alan Cunningham, technical director for Gaffney, Cline, & Associates.
For service and supply companies this reduces demand, and changes the priorities of customers. “Optimization now shifts to minimizing costs rather than maximizing barrels,” said David Deaton, chief advisor in production solutions for Halliburton’s Landmark Software and Service. “Now they are focused on cash management, and lowering the cash cost per barrel even if it impacts production.”
Shrinking
Layoffs have come in waves and that is expected to continue. It began with service companies and suppliers reducing capacity and costs as they adjusted to reduced demand and deep discounts demanded by E&P companies. By year’s end, operating companies were increasing their share of reductions as it became apparent that prices were not going to recover soon. Reductions in estimated reserves offered an abstract measure of a concrete change—less oil is likely to be produced from high-cost plays, reducing the need for workers and equipment. And the methods used to reduce those production costs are designed to get more out of the ground, often with fewer wells and people, further reducing the demand for workers even if prices rise back above USD 50/bbl.
Depressed prices are “destroying a significant portion of the oil and gas industry in the US,” said John Graves, the owner of Graves and Co. While he makes his living running a firm offering transaction services and operating advice to E&P companies, he took on a project to track oil industry job cuts because he thought other counts were too low. By year end, he estimated that global job losses exceeded 250,000.
Companies also are backing away from projects that represent a significant amount of future production. A study from Tudor, Pickering, Holt & Co. reported that 150 projects had been delayed or canceled. That will reduce production in future years from reservoirs holding an estimated 125 billion barrels of oil. The projects were in the oil sands, liquefied natural gas production, and deep water in countries demanding a large take of future revenues.
North American E&P companies that survive 2016 will need to be efficient, financially strong, technologically savvy operators able to respond to sometimes short windows of opportunity.
Companies are redefining their strategies to allow quicker reactions to changes in the business, and a shortening of the time between spending and production. Rather than defining their options as unconventional versus conventional, many firms are talking about short-cycle versus long-cycle primary assets, Phillips said. The goal is to manage projects large enough to matter to a big operator “but still be flexible enough to make relatively short-term moves on the demand and pricing side,” he said.
Rather than commitments stretching out for years, these development plans can be adjusted on a quarterly basis. For example, ConocoPhillips explained its decision to get out of deepwater exploration and shift its spending to onshore by saying it was trying to get away from projects demanding large capital investments where there are years between discovery and first production.
“The North American unconventional plays can also be considered to be optional plays, with lower costs and quicker times associated with switching on or off investments,” Cunningham said.
Last year, Scott Sheffield, chairman and chief executive officer of Pioneer Natural Resources, described a short-cycle approach this way: “at USD 70 (per bbl) we can grow. At USD 80 we can grow more.”
That approach could put a lid on future prices. “People are ready to drill at the drop of a hat,” Ingham said. “The industry is really almost spring-loaded to respond to a relatively small uptick in price, which stomps out any sniffle of recovery you have.”
Lower prices push producers—including national oil companies with the lowest-cost conventional reserves—to reduce their cost per barrel. The combination of efficiency and quick response could create an oil business like the North American natural gas business, where production has remained high despite prices at or below USD 2 MMBtu in the heart of the winter heating season.
“That is what points to a scenario we do not want to talk about out loud,” Ingham said. “It is worth mentioning that producers live in fear of a crude oil market post-2014 that is like the natural gas market.”
Prepare for Market Turbulence
When these charts were created by the US Energy Information Administration in early December, the consensus was that prices would rise this year to around USD 50/bbl. At that time it appeared demand growth would catch up with supply. Charts courtesy of the US Energy Information Administration, Short-Term Energy Outlook.
Then the OPEC meeting ended with no deal to limit production, causing prices to plunge on fears of a lingering supply glut.
Depressed prices, though, may finally force producers in the US and other non-OPEC countries to reduce output.
