Oil Price War Reinforces Need for Structural Change
Find out why the global oil price war, triggered by Saudi Arabia and Russia's refusal to curb production to stabilize prices during the coronavirus (COVID-19) outbreak, reinforces the need for structural change.
The global oil price war started by Saudi Arabia over Russia's refusal to agree to production cuts needed to stabilize prices during the coronavirus outbreak greatly worsened an already tough situation for the U.S. energy business. I believe that current oil prices are unsustainably low, but since it's unclear how long the Saudis and Russians can tolerate the pain they've inflicted on themselves (and the rest of us), it's hard to forecast what the ramifications will be. In the short-term, the economic impact has certainly been sudden and severe.
If oil supply and demand is not balanced soon, we can expect a significant decline in U.S. drilling, production shut-ins, job losses and more producer and oilfield services bankruptcies. Considering that U.S. oil production probably has a first-year base decline of 40%-50%, it's not far-fetched to speculate that the Saudis are out to damage the U.S. shale industry as much as bring the Russians back to the negotiating table.
With the shock waves of the Saudi action still bouncing around the global economy, it's too early to speculate about how this part of the story ends, so I want to comment briefly about the transition that the U.S. upstream industry was in the midst of before the coronavirus outbreak. A couple of weeks ago, Kimmeridge Energy released a paper titled, "Preparing the E&P Sector for the Energy Transition: A New Business Model.” The paper provides a good summary of the last decade's performance of the sector, the challenges it currently faces and five steps to make the sector attractive to investors again.
Ultimately, these steps are intended to allow companies to generate free cash flow so they can return value to investors through dividends and stock buybacks. A key requirement is a relentless focus on costs at all levels: capital, operating and G&A. For example:
- Reduce G&A from a typical 16% of cash flow to less than 5% - This level of G&A is essentially "world-class" and will require a rethinking of how companies are organized, staffed and compensated. In my opinion, companies will have to consolidate to gain economies of scale, use more outsourced staff to increase efficiencies and become flatter. Staff with broad, hands-on skills will be critical.
- Improved capital efficiency through high-grading - This is clearly needed and an obvious solution, but also easier said than done. Most companies are always trying to high-grade. Going forward, successful ones will improve their data analytics to objectively assess all of the data they have, slow down their investment decision-making enough to incorporate their learnings and a do a better job of identifying and managing risks. Growth for growth's sake and drilling solely to hold acreage is over.
To date, I've seen only a few companies that are strongly moving in the direction of cost control, investment high-grading and free cash generation at the level Kimmeridge advocates. It seems, however, it's what investors in today's market are looking for; time will tell how the events started this week will influence the transition.
This article was published in the March 10, 2020 issue of the RED Weekly E&P Update Newsletter
About the Author:
Steve Hendrickson is the President of Ralph E. Davis Associates, an Opportune LLP company. Steve has over 30 years of professional leadership experience in the energy industry with a proven track record of adding value through acquisitions, development and operations. In addition, Steve possesses extensive knowledge of petroleum economics, energy finance, reserves reporting and data management, and has deep expertise in reservoir engineering, production engineering and technical evaluations. Steve is a licensed professional engineer in the state of Texas, and holds an M.S. in Finance from the University of Houston and a B.S. in Chemical Engineering from The University of Texas at Austin. He currently serves as a board member of the Society of Petroleum Evaluation Engineers and is a registered FINRA representative.