While some predicted it, most of us never saw it coming. The uncertainty and pace of change in the upstream sector over the past month has been spectacular and has turned businesses and our lives upside down.
Keeping perspective is difficult in times like these but it’s more important than ever. Stepping back, one can see short term it’s going to be tough, although we can also be confident it won’t last forever.
A macro view
Initially struggling to navigate a sharp and unexpected commodity price decline due to the breakdown of Opec plus in early March, the industry was already hunkering down for a challenging period.
Enter Covid-19. We have witnessed huge destruction in hydrocarbon demand. It’s expected that 20 million barrels, or 20% of the world’s daily oil requirement, will be lost in April alone.
High supply, low demand. The world is drowning in oil and prices are being crushed.
While the benchmark crudes like WTI and Brent are trading in the low $20s, the reality is that many oil and gas companies are having to sell their barrels at far lower prices to offload them. In the extreme, a US blend Wyoming Asphalt Sour has turned negative per barrel, in part due to a lack of storage options.
The world isn’t running short of storage with 29% of global capacity remaining, which could accommodate 90 days of excess production. The problem is that it’s not necessarily in the right places. Canada’s storage is filling fast and Cushing, the main hub in the US, could be maxed out in May.
This is prompting a surge in pricing for very large oil tankers as traders look to secure storage and take advantage of the contango, a situation where future oil prices are higher than todays. Vessels that were $30,000 per day a month ago are now reaching $200,000.
A key point here is that future oil prices are higher than today.
The markets don’t expect the current situation to last forever but that, after this period passes, we will resume our lives and oil demand will recover and grow. Expectations from the International Energy Agency forecast that recovery will start in the third quarter this year with eventual growth of 2.1m barrels in 2021.
The upstream industry is led by exploration and production companies that determine activity and drive spending. In the past two weeks many have been preparing their teams for home working, ensuring continuity of operations and re-cutting the 2020 budget to conserve cash.
E&P companies have an element of protection in that they have hedged or forward sold their production at a higher price from current levels. In the UK this may account for 60-70% of production for 2020. Many won’t be feeling the full impact of the commodity price reductions just yet, although there is little hedging in place for 2021 so protection is temporary.
This time round the UK Continetal Shelf basin is in far better shape than it was entering the 2015 downturn. The efficiency drives and cost reduction initiatives reduced substantially the cash breakeven costs of production to $20-25 per barrel. While E&P won’t be making much money at today’s prices, they are not going bust either.
This said, there is no doubt that a significant reduction in expenditure is looming. E&P firms are cutting all non-essential spending which will impact decommissioning, drilling, project work, and maintenance activities. The focus is on safe production and limited spending. New projects and discretionary expenditure will be delayed or cancelled.
Revised estimates of global upstream spend for 2020 vary among the market analysts, though Wood Mackenzie points to £80 billion of spending at risk, a 25% reduction from their initial forecast. Project sanctioning is also expected to fall back to 2015 levels.
The OFS sector
Most oilfield service (OFS) firms globally have not recovered from the 2015 downturn and are already working on tight margins and vastly reduced activity levels.
There have been doomsday press releases that predict massive job losses and that 20% of North Sea OFS firms will go into administration. I think it’s a little early to call.
EY, in its annual review of the UK OFS sector, noted there were 1,200 firms in 2018, an 8% reduction from 2015. The extent of this downturn has yet to be seen but company failure or success is down to many characteristics, not market dynamics alone.
While the E&P companies have some breathing space and are better prepared this time round, the OFS community is not. Their future will be dependent on the speed of recovery, how quickly they are paid by clients, financial support options and fundamentally the strength of their proposition.
All companies think they are unique, and they are. Many confuse this, however, with real differentiation, or the ability to provide a product or service which others can’t.
OFS providers that are differentiated will weather this storm better than most. The more commoditised businesses will struggle unless they are able to produce at the lowest marginal cost.
It’s all about relative pricing in this sector and they need to be prepared.
Many businesses will need to evaluate what is likely to happen to their market and customer behaviours, in addition to analysing where their strengths really are. Firms really need to understand where they add value and how to maximise it, which will likely require different approaches and focuses from those of the past.
Hydrocarbons are the primary source of global energy demand and will continue to be so for the coming decades. The real impact of this crisis is all about how long it lasts.
Key questions surround the longevity and extent of demand destruction due to the virus and the distancing measures, while the supply side pressure will be determined by how long Saudi Arabia and Russia lock horns in their supply war.
On the demand side we can look to China regarding potential timelines. Having suffered earlier than Europe and other regions, we are now starting to see the easing of restrictions and oil demand increase again. As mentioned, the current state won’t last forever.
Despite what they may say, neither Saudi nor Russia can stomach $20 oil for long. Everyone loses. Saudi still requires oil around $80 to fiscally break even. While they have cash reserves, these were materially reduced during the last downturn.
Someone will blink soon.
Andrew Reid is a management consultant supporting executive teams with evidence-based strategic evaluation and implementation at NorthStone Advisers