Energy’s Pickup Sticks Game Becomes More Interesting
“The jumble of last year for the energy business was like the kid’s game pickup sticks. Companies have been picking up sticks via mergers and acquisitions to prepare for the improving market and strong 2022 outlook. ”
Growing up, on rainy days we would often play games. One challenging game was pickup sticks. A bundle of sticks about 7-8 inches long are dropped onto a table, jumbling into a random pile. Then each player in turn tries to remove a stick from the pile without disturbing the others. This game came to mind as we contemplated the energy industry for the past 12 months. We would suggest that the game started last spring when Covid-19 arrived. Health and economic events of last March/April were the equivalent of dropping the bundle of sticks for the oil and gas industry.
At first, everyone sat around staring at the jumble of sticks on the table, trying to figure out if there were an easy play. They quickly realized things were going to become tough. Initially, people focused on whether the table was stable. How could you venture to pick out a stick if the table is wobbly? Determining that the table was stable took time, which is why cutting costs was the highest priority. With a stable table, some players successfully pulled out sticks. It was the larger oil producers who dominated that phase – Chevron/Noble Energy; ConocoPhillips/Concho Resources; and Devon Energy/WPX Energy. The pace picked up as the year progressed, as well as it broadened out to the midstream and oilfield service sectors. Now, more players are engaged in “picking up sticks.”
Last year with the emergence of Covid-19 and the belief that locking down economies was the only way to fight the spread of the virus was the equivalent of dropping the bundle of stick. Things went in all directions – travel ground to a halt, shopping and eating out were banned, along with commuting to work. With economies operating on one-cylinder, oil and gas demand collapsed, and oil prices followed. Oilfield activity was crushed, thousands of workers were shown the door, and bankruptcy lawyers were put on speed-dial. Cash flow vaporized and many companies were operating on fumes. While the opening line of Charles Dickens’ A Tale of Two Cities seemed an appropriate description, unfortunately, there was “no best of times” for any city.
By fall, prospect of vaccines against Covid-19 and a return to normalcy in a matter of months unleashed the juices of optimism. States and countries began reopening – at least somewhat – and increasing economic activity boosted energy consumption, surprisingly, even for oil and gas. The rebound in oil and gas consumption produced projections for further increases in activity in the second half of 2020, but more importantly, in 2021. The recovery trajectory suggested the possibility of an oil supply shortfall in 2022 due to inadequate industry spending during the past few years. That could send oil prices soaring.
Oil prices now seem to be settling in the low $60 per barrel for WTI and the high-$60s for Brent ranges. These prices are in line with the historical inflation-adjusted oil price. Does that mean we have reached a market equilibrium, or are we at the start of another step higher? While nothing yet can be considered normal, confidence about the economic recovery and higher oil prices is becoming a key feature in the industry’s outlook. As a result, drilling and completion activity has started inching upwards. For many observers, the idea of increased oilfield activity is shocking, as they have yet to adjust their thinking to the new reality. An indication of this thinking was seeing a recent five-rig gain in the weekly Baker Hughes rig count being called a “surge”!
As we are about to start the second quarter, the question is not about a recovery in the oil patch – it is about the angle of ascent. How permanent will behavioral changes impacting energy demand be in the future? If people continue working from home and schools and universities continue with their great online learning endeavors, we can expect a much slower return to pre-pandemic energy consumption levels. On the other hand, if most workers return to their offices and schools reopen, commuting will fuel a consumption rebound. Jet fuel’s future is more questionable, as both business and leisure air travel will likely take much longer to recover. The yin-and-yang of cabin fever versus fear of crowds and Covid-19 protocols makes predicting the pace of jet fuel rebound difficult.
The recent Dallas Federal Reserve Bank energy survey showed how optimism is driving current and future oilfield activity. The overall business activity index jumped from 18.5 in 2020’s fourth quarter to 53.6 in 2021’s first quarter, reaching the highest level in the survey’s 5-year history. Of course, the survey essentially covers the recessionary period for the industry that commenced in 2015 when oil prices crashed after Saudi Arabia stopped supporting oil prices at the end of 2014 and undertook an aggressive market share recovery effort. The devastation that has marked the recent history of the oil and gas industry has established a low bar for measuring improvement.
While we will not recite the list of activity measures that have jumped between the two quarters, there can be little doubt that they have been driven by higher oil prices, with expectations for even higher ones on the horizon. That optimism was reflected in survey respondents predicting a $61 per barrel oil price for year-end 2021. While that is below the $64 a barrel price that existed during the days survey responses were collected, the range of year-end oil price forecasts was astounding - $45 to $85. Only 3% of respondents see oil prices below $50, but 42% expect prices greater than $62. What is important is that each end of that forecast range can be defended, depending on your economic assumptions.
The Dallas Fed asked people about their outlook for the energy industry over the next six months, and the response called for more than a threefold increase in the index - from 21.6 to 70.6. That represents the highest level in the 5-year survey’s results. Equally impressive was the uncertainty index falling eight points to -22.2, the lowest level since 1Q2017 when the survey began.
The Dallas Fed survey offers a glimpse at one of the key factors in the dynamics that will determine where the oil and gas businesses is headed. That factor is the estimated price by basin for profitably drilling a new well. While the upper end of the range for every basin exceeds current oil prices, the median values offer a healthy profit for most wells. With oilfield service company pricing starting to rise in response to increased activity, input costs for equipment and wells are also increasing, especially for steel that forms the basis for casing, tubing, and drill pipe, which will begin to pressure overall well costs. How quickly inflation will impact overall well costs is uncertain, but oilfield service companies will be pressured to improve their financial results that require increased utilization and better pricing.
Exhibit 8. How Producers See Well Costs By Basin SOURCE: Dallas Federal Reserve Bank
The lower well cost estimates were supported by industry consultant Rystad Energy. In its compilation of annual well costs from 2014 to 2021, we see a definite downward trend. Rystad focuses extensively on shale drillers because that is what most U.S. activity is these days, and they suggest the cost improvement has been accompanied by higher well productivity, a trend it expects to see continue over the next few years.
Rystad sees shale drillers keeping their capital spending flattish this year, up $100 million or a 0.4% increase. That is up substantially from its earlier estimate after 3Q20 earnings reports by producers when Rystad expected spending in 2021 to be 8-10% lower. The recovery in the spending projections is reflective of what has happened to oil prices since last fall, with WTI up 50% from $40 per barrel to now $60. Higher oil prices mean more cash flow for producers and better well economics to target in its use. With reduced uncertainty about the outlook, as reported in the Dallas Fed survey, we should not be surprised producers anticipate spending more money this year, and in 2022, also.
Exhibit 9. Well Costs Have Been Trending Lower SOURCE: Rystad
Given the importance of the domestic oil and gas industry for the economies of Texas and the United States, it is no surprise that we focus on domestic well costs, capex spending and the growing optimism of the industry about the future. However, international spending and activity is also key to the health of the global oil and gas industry, and especially for the global oilfield service industry. Wall Street analysts who track oilfield capital spending plans are updating their survey results from last fall. In those updates, it appears domestic producers are holding their capex spending flat to slightly lower, while international spending continues inching higher from last fall’s initial estimates.
An evolving development that is likely weighing on domestic oilfield spending is the current federal moratorium on leasing federal onshore and offshore acreage. This moratorium is supposed to give the Biden administration time to assess the entire federal government’s energy program. It came into office with an anti-fossil fuel agenda. Every action it plans to do will be evaluated through the lens of climate change and social justice. The administration sees renewable energy as our future for powering the domestic economy, regardless of the reality of its intermittency and cost.
The Biden administration’s push for a net zero carbon emissions future is in keeping with the energy policy approach of the European Union (EU). This has driven those international oil companies headquartered in Europe to embrace green energy and shun fossil fuels, despite their corporate legacies. The latest fallout from this embrace came from Royal Dutch Shell who cut in half its long-term growth rate for global natural gas demand to 1% per year. It also said global natural gas demand could peak as soon as the 2030s. Maarten Wetselaar, head of Shell’s gas business, told an energy conference last month that “If you look at the global gas industry, its role in the energy transition and the world energy mix decades from now is up for grabs.” This view imperils Shell’s long-term natural gas strategy that involved the 2015 purchase of BG Group, which followed on a 2014 deal to buy Repsol’s REP.MC LNG business.
Cynically, Shell’s move may be more a reflection on the future competitiveness of the global LNG business following Qatar’s recent announcement to massively expand its LNG business and end its LNG joint venture with ExxonMobil and Total that has been in place since 1984. At the present time, Qatar can supply 77 million tons per year (mmtpa) of LNG and is in the process of expanding that output to 110 mmtpa. With the new expansion plan, it will grow LNG output to 126 mmtpa. In Shell’s “LNG Outlook 2020,” the company estimated the global LNG market in 2019 at 359 mmtpa. Qatar represented over 20%. Shell said it expected the market to double to 700 mmtpa in 2040, at which point Qatar’s market share would shrink to about 18%. If Shell’s new market growth assessment is correct, the global LNG market will only grow to about 430 mmtpa, of which Qatar would claim nearly 30%. Under that scenario, the competitiveness of the global LNG business would change dramatically. What does this mean for Shell’s gas strategy?
As energy executives grow more confident about higher future oil prices, they wrestle how to balance financial discipline, unexpectedly greater cash flows, growing the company’s assets, and treating shareholders fairly. Few companies prepared their budgets and capital spending plans based on oil prices in the $60s. Many of them used $45-55 per barrel prices. The difference between these budget prices and revenues, if not limited by long-term hedges at lower prices, means more money coming in the door than predicted. Do they spend it? Maybe they can pay down more debt. Or they could send the money back to shareholders in the form of dividends or by purchasing shares. It is also possible they might just allow the excess cash to build up on the balance sheet, but given low interest rates, these cash balances earn little for the company. As hard as it is to imagine, companies might spend more money drilling new wells and finding more oil and gas reserves. Imagine growing the asset value of a company.
It is also possible higher oil prices may help companies avoid bankruptcy. That assumes companies are not already in such financial difficulty that they need the protection of the bankruptcy courts to negotiate a balance sheet restructuring. For companies who have not sought bankruptcy protection but remain highly leveraged, the extra cash flow may help them navigate to an improved financial position. Oilfield service companies remain at risk if activity remains depressed. Unless equipment is utilized, income is not generated. In addition, drilling, completion, and production equipment will require maintenance and replacement when worn out, representing a call on cash flow, much like debt service. This is the single most complicating factor in restructuring oilfield service companies in a low activity, low price environment.
These pressures may become a catalyst for mergers and acquisitions, such as the recent combination of offshore drilling companies Noble Corporation and Pacific Drilling Company LLC. in an all-stock transaction, or the Frank’s International and Expro Group. We are also seeing combinations of producing companies, too, such as the recently announced Pioneer Natural Resource Company and DoublePoint Energy LLC. The deals being announced reflect management and investor confidence in the ongoing industry recovery rather than attempts to deal with impending financial disasters. We will see more producer and oilfield service company mergers and acquisitions as this recovery progresses. This is a natural progression during an industry recovery – something that occurred during every prior cycle. Mergers and acquisitions enable companies to improve their financial position, upgrade their fleets or boost their production output, while also increasing operational efficiency. There will be fewer companies, but they will be financially stronger and more efficient. This better positions them to navigate the challenges of the industry’s future, including the energy transition. Each move is akin to picking up sticks, hopefully, without disturbing others. The game continues.