You’ve probably seen the headlines: On March 9, oil prices experienced one of the most significant price drops since 1991.
Why did this happen? The severe collapse is a direct result of failed negotiations between OPEC (Organization of the Petroleum Exporting Countries) and Russia. With COVID-19 causing an economic slowdown, OPEC recommended an oil production cut to accommodate reduced demand. Russia seemingly perceived that a cut by OPEC and Russia would favor US shale producers, whose production growth has shifted oil flows and weakened the relative position of both OPEC and Russia1.
Failing to reach an agreement, Saudi Arabia announced that it would seek to gain market share by offering discounts to customers in Northern Europe, the Americas and Asia. Additionally, the country announced that it intends to add 2 million barrels per day to its production over the coming months. The United Arab Emirates followed Saudi Arabia’s lead and promised to raise output in the near future as well.
This announcement contributed to the drop in oil prices, which are now at levels not seen since 2015. While not as severe as the price collapses of 2008 or 2014, the underlying driver—to take out production capacity—is no less troubling. The impact of this move is already being felt as the rig count has dropped, companies have curtailed discretionary spending, capital budgets have been cut and earnings forecasts reduced. Oil and gas stocks across the value chain have been rocked. This is putting some companies at risk of not being able to refinance debt or meet existing debt covenants.
Prices for Brent crude have dropped into the $35 per barrel range. Given we have not seen prices in this range for several years, few companies have scenario-planned for $30 oil.
How long will the downturn last, and how far out should companies plan for this lower-price environment? That depends. While prior downturns have varied in length, this situation seems likely to be of a shorter duration. If Russia and OPEC reconcile and arrive at a mutually acceptable production cut, we could potentially see a near-term recovery.
However, betting on personalities and relationships is an unpredictable exercise. A more likely scenario is a prolonged recovery as the market strives to rebalance after Saudi Arabia adds 2 million barrels per day and demand recovers from the COVID-19 impacts. Given normal production decline curves, it could take up to a couple of years to rebalance the market under this scenario.
As with previous downturns, the industry has moved to cut discretionary and capital spending. Going forward, a key question for all oil and gas companies should be: Do you have the financial reserves to weather the storm or even capitalize on the tumult in the industry?
Operators will also likely reduce their capacity and cost structure through staff reductions and related measures as their activity levels decline. However, each company first will want to assess its positions by reviewing its balance sheet and liquidity to reset the company’s baseline. From there, it can develop its options as it faces a new price environment.
Next, companies should assess how profitability and cash flow generation can support ongoing operations. At current price levels, how much cash will their assets generate? To quantify asset profitability, they’ll need an understanding of their cash operating expenses, taxes and other cash expense items. The analysis should be at the field or well level, as cash forecasts will be dependent on this “cash margin” against the decline curve. Finally, companies will want to carry out a review of capital and corporate cost budgets to identify not only marginal investments, but also those discretionary items that can be culled.
Once a new baseline is established, companies can develop scenarios and strategies. While the initial urge is to react with austerity, taking a more measured approach will likely yield a better result. Austerity measures should be tempered to preserve long-term objectives. While moving quickly may create an advantage, knowing where you’re going makes your moves more impactful.
What else should companies do to respond to this crisis? Here are some strategies based on lessons from prior downturns:
Understand your position. Determine the health of your balance sheet and cash flow. Know how to generate free cash and profits in a low-price environment and find your break-even point.
Be surgical with cuts, while balancing short- and long-term needs. Plan for the future after prices begin to recover. What assets, people and capabilities will you need or want then? Look for ways to preserve what you will need later.
Look for opportunities with an innovative eye. Whether dealing with suppliers, customers or partners, seek alternatives that allow you to preserve relationships, co-create solutions and sustain both businesses. Look for M&A opportunities, as distressed assets or non-core assets are a potential source of cash for embattled companies. These opportunities often lead to lower cost structures, expanded business and sustained relationships.
Search for areas to outsource. If you’ve looked into outsourcing portions of your corporate functions, moving your IT to the cloud, or moving internal non-core operating functions to contractors, now is the time to revisit those options. These changes can help lower your operating costs and reduce maintenance capital.
Be ready to ramp back up. Look for signs of a turnaround. Has production dropped to meet demand? Are Russia and OPEC moving closer to a deal? Again, being a first mover will help create opportunities, allow you to capitalize on the oil price recovery, and lock in lower rates from suppliers as you become one of the first to increase spending.
These steps can help oil and gas companies avoid many of the pitfalls of prior downturns. The oil and gas industry is cyclical and volatile and will remain so. Successful companies have weathered many of these downcycles and have often emerged stronger. While these downcycles are painful, measured, informed decision-making can help position your company to capitalize on the market recovery.
1 “Saudis Instigate Oil-Price Clash With Russia” WSJ 3/9/2020