Investing in capital markets is, speculators aside, a long- term play. When times are good investors can relax and take pleasure in their investment prowess; when times are bad investors need to remind themselves, they are in for the long term, and play to the fundamentals.
So, what are the fundamentals?
Following the downturn in 2015 the exploration and production (E&P) sector managed the impact through capital discipline, greater focus on production activity, repricing much of the supply chain, and selling non-core assets. Generally, the E&P companies returned to positive cash flows fairly quickly, albeit shareholder returns were reduced from the halcyon days of US$100+ per barrel oil. Much of that stabilising of the E&P sector was underpinned by supply side discipline introduced by the so-called “OPEC plus” nations, which brought the oil price back into the US$55 to US$65 range. The price remained susceptible to movement but more as a result of perceived variance in demand.
On the whole, global demand remained steady and on a gradual increase, with the first sense of near-term fragility in the oil price being introduced by the trade war between the US and China, and the potential for reduced global economic growth. Then suddenly COVID-19 took hold and started to sweep across the world.
Against the very real prospect of falling demand for oil, OPEC plus met to discuss further cuts in supply. These were seen by some as unpalatable and the result was an immediate crash in oil price as even the existing supply discipline was abandoned.
The crash in oil price has been quickly followed by many countries, including the UK, adopting lockdowns on their citizens to counter the spread of the coronavirus with a knock-on impact to economic output.
The consequences for the UK oil industry and the economy of the North East are likely to be significant.
A return to supply side discipline will not happen quickly. The invitation for US participation in the next OPEC plus meeting in June is a welcome development but how that could result in US oil producers, many of them champions of the free market, agreeing to production cuts is hard to imagine. In the meantime, demand for oil is likely to reduce by a material amount, exacerbating the oversupply.
Both the E&P companies and the oilfield services (OFS) sector have few levers they can pull at this stage to ensure financial viability. The most obvious is to cut costs – which is very difficult in sectors where costs had already been squeezed in recent years, and in OFS in particular where margins have not recovered from 2015. Already there are a wave of announcements by the listed companies: capital expenditure cuts, salary reductions, putting staff on furlough (working one week and then on unpaid leave the next), reduction in dividend payments, suspension of share buybacks etc. One analyst has suggested that the current cumulative announced reductions in spend in the sector are $67bn of capex, $8bn of opex and $15bn of share buybacks – quicker and deeper cuts than those made in either 2009 or 2015.
The short-term outlook for the industry is extremely challenging.
Going back to the fundamentals, provided steps can be taken to counteract COVID-19 or at least manage the impact more effectively, and the various stimulus packages can start to take effect as lockdowns are relaxed then a return to growth in demand for oil will happen.
Moreover, the current situation may remove some of the production capacity in the US, or at least take the gloss off unconventional production for many investors. A survey of E&P and OFS companies active in unconventional resources, undertaken by the Federal Reserve Bank of Dallas for 1Q2020, found almost 40% of firms estimated they would become insolvent with two years if the oil price stays below US$40. This, along with a return to supply side discipline, which is inevitable as no producing country wants a long term very low oil price, will bring the oil price back to the range we have experienced over the past two years.
Therefore, the medium-term and long-term outlook is still positive. Like 2015, all businesses in the North East linked directly or indirectly to the oil and gas sector will be impacted by the oil price crash and that will be exacerbated by the current COVID-19 situation.
The companies which respond quickly and take steps to: ensure the safety and wellbeing of their people; monitor and adapt to risks facing their operations; manage cash flow and strategically engage with all stakeholders through this difficult period will emerge in a better position to profit from the medium and long-term fundamentals. The stimulus measures announced in the UK allowing for deferral of VAT payments and self-employed income tax payments on account; salary support for furlough employees; and loan guarantees may also help businesses weather the near-term liquidity issues.
Thankfully the downturn of 2015 has caused many of the OFS and related supply chain companies to embrace a wider energy strategy and to examine how their technical competencies can be utilised to respond to the need to decarbonise production facilities and the broader energy transition agenda.
The current situation, following on from the economic difficulties of 2015, further emphasises the need for the energy industry in the North East to be part of the UK Government’s sector deal. This, and faster progress with the energy transition zone would be a big boost at a difficult time as the region seeks to move the economy away from oil and gas towards an energy mix.