When the energy world was coming apart in March and April, the prospect of any recovery, let alone a V-shaped one, seemed well in the future. Expectations were that demand destruction would be at a maximum in April, which was supported by the decline of oil futures prices into negative territory. Never before had the oil market experienced such an episode, although in select energy markets producers have experienced negative prices, especially wind turbine operators during nighttime hours. At those times, excess power supply often causes prices to drop into negative territory. In those cases, wind generators are supported by government subsidies.

Recent oil market data seems to support the view that oil demand destruction was less than forecasters’ worst-case scenarios. Everyone expects that May’s data will show meaningful demand improvement, as well as a smaller inventory build, as economies began opening and oil production was cut. Traffic data supports that view. The challenge in forecasting oil demand near-term is the uneven economic reopening, as well as the fallout from the protests and riots provoked by the tragic death of George Floyd in Minneapolis. But there is another overhanging concern about the future direction for oil demand, which is what is happening in China.

China was the site of the initial outbreak of Covid-19, which forced the government to lockdown Wuhan, the site of the infection, and then much of its country in an attempt to control the spread of the virus. By being the first to experience the virus, the first to lock down its economy, and the first to unlock its economy, China’s energy data has been the beacon forecasters are watching for guidance about the pace of the world’s energy industry recovery. While initial data showed a sharp upturn in economic activity, disruptions in company supply chains have limited the upturn in manufacturing output and power consumption growth. Fear of contracting the virus has led to an increase in personal driving to work, rather than relying on mass transit in major cities. Thus, vehicle congestion quickly returned to pre-virus levels on workdays. However, traffic on weekends has not returned to earlier levels, as citizens are reluctant to venture out. Now, we are hearing that weekday traffic and energy consumption has stopped rising, and may, in fact, be falling slightly. We suspect this weakness may be tied to the supply-chain disruptions that are keeping manufacturing plants from running a high utilization, likely meaning fewer workers are needed. These disruptions are probably more localized, rather than nationwide.

Could the same pattern in driving and overall energy consumption unfold in the U.S.? It has to be considered a high probability once most of the economy is reopened. Therefore, we expect to see a continuation in weekly energy consumption growth, before the rate of increase slows and potentially moves sideways. While the oil industry and the energy market can tolerate such a pattern, what will always be lurking in the background is the possibility that a fall outbreak of Covid-19 could send the economy back into restricted economic activity and a fall in energy demand. There is probably little risk of total shutdowns of states, but shutdowns of cities and regions that suffer a second virus outbreak have to be considered a realistic possibility. If that happens, it will snuff out prospects for a robust energy demand recovery.

A favorable economic recovery outlook has underpinned the dramatic recovery in oil prices. The Energy Information Administration (EIA) had an interesting chart on its web site. The chart showed how Brent oil prices have largely traded in a flat pattern from 2017 to early 2020. The range of prices was from the mid-$40s in spring 2017 to about $85 per barrel (/bbl) in the fall of 2018. The chart also showed the Brent price as of the first day of each month in 2020. The average price for the first six months of 2020 is $43.50/bbl. Of course, that was influenced by the high oil prices experienced during the first three months of the year. The IEA is forecasting Brent oil will average $34.13/bbl for 2020, down 46% from last year’s average. What is interesting is that if we assume the Brent price trades flat with its June 1st price for the remainder of the year, that produces an average of $40.75/bbl, considerably above the agency’s projection. According to the June Short Term Energy Outlook (STEO), the EIA has increased its oil price forecasts, lifting Brent from $34.13/bbl to $38.03/bbl That means the EIA either believes the Brent oil price will drop for some period of time during the rest of 2020, or the EIA needs to revise its forecast even higher.

Is The Oil Price Forecast Too Low?

While a further recovery in global oil prices would certainly be welcomed, it should not be expected to dramatically alter the thinking of E&P companies. They will want to see oil prices rise further, and remain elevated for some period of time before E&P companies begin spending. The initial actions of these producers are to restart production shut-in during the depths of oil prices and height of fear over the onslaught of crude oil exports heading to market. With WTI prices in the mid-$30s/b, reports from the oil patch and E&P press releases confirm that reopening shut-in production is underway. At some point, should the demand recovery falter, oil prices will drop. How far down they fall depends on the degree of change in sentiment about the underlying demand factors.

How Rigs And Oil Prices Moved In Recent Years

The linkage between oil prices and active drilling rigs is tight. The drilling rig count peaked coincident with the bottom of the oil price decline in 4Q 2018. Although oil prices subsequently recovered, they never returned to the $70/b level that marked their recent peak. The oil price recovery in 2019, following the 2018 low, reached price levels commensurate with early 2018. That recovery did not prevent the rig count from steadily sliding. That slide continued throughout 2019, despite oil prices trading within a fairly narrow range. In fact, oil prices began to climb late in 2019. As we entered 2020, oil prices weakened, but, fortunately, the rig count held up. That all changed

Exhibit 10. The Current Rig Downturn Approaches Last DeclineSource: Baker Hughes, PPHB — Exhibit 10. The Current Rig Downturn Approaches Last Decline
Source: Baker Hughes, PPHB

when oil prices collapsed in sync with the black swans of Covid-19 and the Russia-Saudi oil war. The rig count then fell at one of the fastest paces in history.

Exhibit 10 shows multiple rig count declines since 1980, indexed to their peak. Each decline has its own shape and pace, reflective of industry events occurring during the declines. While the 2019-2020 rig decline may not be over, it has reached a point where it matches the 1984-1986 decline. If it continues, it may approach the scale of the 2014-2016 rig decline.

The shape of the 2019-2020 decline, a slow decline and then a collapse, reminds us of Ernest Hemingway’s dialogue in his book, The Sun Also Rises.

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

“What brought it on?”

“Friends,” said Mike. “I had a lot of friends. False friends. Then I had creditors, too. Probably had more creditors than anybody in England.”

Oh, my! Mike might have been an energy CEO describing those who have become the bane of the oil and gas and oilfield service companies. The companies, swept up in the shale revolution and needing cash to buy acreage and drill wells, were shoveled money by investors, happy to snap up equity and bond offerings to assist the companies to grow. Now, they want their money back, and the companies don’t have it, nor are they likely to get it.

How Bad Is The Energy Equity Market?

As oil prices rose in the early-2000s, the number of equity offerings and the amount of money raised by energy companies increased.

Fundraising remained stable, with the exception of the Financial Crisis years, but exploded in 2016 in response to years of $100/b oil prices and expectations we would soon revisit those levels again. Since then, however, investors shunned shale producer offerings, demanding the companies demonstrate greater financial discipline, that they live within their cash flows and actually return excess cash to the shareholders. There was a lag between investors embracing shale producers and then acknowledging that they were largely destroying, rather than creating shareholder value. In high-risk debt markets, investors were also infatuated with shale companies, or at least they liked the yields those companies were willing to pay to raise capital. All the debt investors bought has now become a monumental challenge to the survivability of companies. The blue bars in the chart in Exhibit 12 represent the number of issues of high-yield debt offered.

How Energy Debt Market Changed

The magnitude of the challenge facing the industry is shown by the progressively taller columns representing debt instruments from 2020 to 2022. From approximately $38 billion of debt in 2020 to $55 billion in 2022, the debt repayment challenge for oil and gas companies grows. The ability of the industry to repay, or even refinance, this debt appears impossible. This wall of debt is what is driving the uptick in bankruptcies, which will lead to an eventual flood of them, and is what haunts the industry and investors.

Oil And Gas Faces Debt Wall In 2022

Over the past decade, private equity investors discovered the shale business and perceived a potential investment opportunity. They were happy to back new management teams in building new shale energy companies – both E&P and service. These new companies offered the opportunity for private equity managers to exercise all their skills – picking managements, developing strategies, raising capital (especially with a financial structure that facilitates the use of leverage), acquiring and merging companies, and exiting investments.

Energy PE Has Lots Of Dry Powder

All of this capital market activity was driven by the cheap money that was key to the nation’s recovery from the 2008 Financial Crisis. Once cheap money was unleashed, the Federal Reserve has been unable to turn off the money spigot. High-yield, high-risk debt was purchased hand-over-fist by investors desperate for income to make up for the absence of returns from low-risk government bond yields caused by the flood of cheap money. As debt on company balance sheets ballooned, the race to generate cash flow to stay ahead of debt repayments, while also stepping up drilling and well completions, was underway. That race lasted until the music stopped with the black swans.

The race shifted to how to deal with the debt. Although we know what is coming, the early figures are now in, courtesy of law firm Haynes and Boone who publishes bankruptcy watches for the E&P and oilfield service industries. The results, while listed as second quarter, are actually only through May. The firm announced that due to the impending avalanche of bankruptcy filings, it would begin reporting data monthly, rather than quarterly. Recently, Haynes and Boone energy practice co-chair Buddy Clark, told Energy Intelligence, “It’s possible we get to 100 filings this year. This is just the beginning of what follows the collapse of oil prices from the pandemic. The near-term future is not looking very bright - except for oil and gas bankruptcy lawyers.” He had previously told another publication, "It's hard to believe that 100 bankruptcies is the optimistic view. That just shows you where we are." So, where are we? The latest data from Haynes and Boone shows that 14 E&P companies filed for bankruptcy during April and May, which was up from only five in the entire first quarter. Those filings represented $11.75 billion of secured and unsecured debt.

The E&P Bankruptcies Are Beginning To Flow

Looking at the oilfield service industry, we see a similar phenomenon. There were only five companies filing for bankruptcy protection during April and May, down from eight that filed in the first quarter. The five companies represented $812.2 million in total debt. Of that amount, 82% was accounted for by Hornbeck Offshore Services, Inc., with $668.5 million of total debt.

How Many Oil Service Bankruptcies Are Coming?

While the most recent bankruptcy data is not a complete surprise, we need to put into perspective the current environment for the energy industry’s financial health. Since the second quarter is not finished, we fully expect to see more E&P and service companies filing for bankruptcy protection. To assess where the industry is presently, we looked at the annual data from 2015.

E&P Bankruptcies Seems To Have A 2-Year Cycle

What is striking when looking at the two charts is the dramatic rise in both the number of bankruptcies in 2016 for E&P companies. That was the second year following the 2014 oil price drop, and it reflected the weak financial position of many shale oil companies prior to the price collapse. When we look at the following years, we noticed there was a jump in companies last year, which followed the oil price fall in 2017. Now, just because we have a pattern, that doesn’t mean we need to wait until 2022 for the fallout from this global oil price collapse and economic shutdown to manifest itself in a spike in bankruptcies. This year will see more bankruptcies, as the weakening of balance sheets and the loss of substantial cash flow heading into this downturn will doom many producers quicker.

Oil Service Company Bankruptcies Will Climb

The pattern of bankruptcies and debt expunged for the oilfield service industry is somewhat different from that of E&P companies. The service industry seems to follow a three-year cycle. Unfortunately, 2020 marks the third year of this pattern. We know from public filings that there are a number of large, heavily indebted oilfield service companies that have hired restructuring advisors and lawyers to guide them through negotiations with their lenders prior to filing for bankruptcy. In other words, there will likely be greater pain to be experienced in the oil patch over the balance of 2020.

The recent employment report for May that showed nearly three million jobs being added, rather than the anticipated nearly nine million jobs being lost, suggests the economy is snapping back as states reopen. Whether the totals are accurate seems to be debatable. What is important is that the growing reopening of states did add more workers to the employment rolls. More people working means more energy will be needed, especially oil and gas, which is tied closely to mobility activity. This data, coupled with the agreement among the OPEC+ parties to extend their production cuts for another month, has encouraged traders to bid oil futures prices higher. The higher oil price is bringing some shut-in wells back into operation. What we haven’t seen is any uptick in new well drilling. That will take longer to begin, as producers will want to see higher prices and for those elevated prices to be sustained for a while. Normally, the lag between upturns in oil prices and a pickup in drilling is about three months. Will the lag be as long this time? The answer probably depends on the financial health of companies, as well as their ability to access capital. The push by investors for increased financial discipline, plus greater emphasis on more attention to environmental, social and governance (ESG) standards and decarbonizing the economy will play into the future recovery and pace of activity. Enjoy the better industry environment, but don’t expect a dramatic activity recovery soon.

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