Turmoil In The Oil Patch Continues; Any Resolution In Sight?
“Oil prices bounce around. Demand in 2021 remains uncertain. How long before we enter a post-Covid-19 world? Oil patch bankruptcies continue, and access to capital is being threatened. What should energy do?”
As we slog our way to 2021, the memories of this year will be gladly wiped from our thoughts. This has been, by any measure, a terrible year. For the energy industry, 2020 introduced conditions never thought possible, but more importantly, they have set the industry on a different tack. With a global economy that appeared to be humming along as we entered this year, the emergence of Covid-19 and the resulting government and social reactions crushed economic activity, along with oil demand. Who would have ever thought, even with those actions, crude oil prices could turn negative – even briefly? But what that price shock did was signal we needed to reassess the industry’s future, and not with rose-colored glasses.
The turmoil that beset the oil industry this spring caused many energy forecasters and practitioners to question when things would return to “normal,” although no one was quite sure what normal meant. Like the blind men trying to describe the elephant, everyone recognized that societies and economies were undergoing behavioral changes that would alter their structural aspects, but by how much and over what time period were unknown. What changes would become permanent, and which ones would be rejected once a vaccine appeared or herd immunity was established, confounded the ability to simply run forecast models and determine reasonable conclusions.
The energy turmoil provided a fertile ground for environmental activists to lobby for a radical restructuring of economies and society to become carbon-free. If governments were looking for financial stimulus steps to boost their economies, rebuilding them on the foundation of electricity and renewables is seen as both stimulative, as well as job creating. Ending the Age of Oil has been embraced by a large segment of the world’s population, providing a new mantra for the future. Clean energy rather than growth in energy output is becoming the new measuring stick for economic progress.
Exhibit 7. Crude Oil Prices Demonstrating Positive Outlook SOURCE: EIA, PPHB
Last week, crude oil prices managed to squeeze out a sixth consecutive weekly increase, helped by optimism about the arrival of the Covid-19 vaccines. This tied the previous six-week positive increase span that happened after oil prices fell into negative territory this spring. The recent price rise reflects the market’s response to the OPEC+ group being able to negotiate a compromise that sees only a small (500,000 b/d) increase in oil supply starting in January, as opposed to the prior plan to add four-times as much. The fact it took extra days to negotiate the OPEC+ agreement was a surprise and upset oil prices. However, the time needed reflects the friction between those members needing additional income but lacking more oil to export, and those capable of exporting more oil but worry the most about another oil price crash. The agreed-to outcome gives the market additional time to see what the recovery of 2021 may look like in light of the arrival of coronavirus vaccines. Reducing that uncertainty should help the future oil price trajectory.
With oil prices crashing this spring, as oil inventories mushroomed when economic activity was shut down due to Covid-19, OPEC+, with the aid of President Donald J. Trump, agreed to a significant supply cut. That agreement envisioned a rapid recovery in world economies and oil demand that would justify adding more oil to the market as we headed into 2021. Therefore, the plan envisioned adding two million barrels per day (mmb/d) back to world supply starting January 1, 2021. The new agreement just reached calls for only adding back 500,000 barrels per day (b/d). What remains unclear is whether the Russian Oil Minister’s comment that OPEC+ will add 500,000 b/d of supply back to the market every month during the first quarter, such that by April the full 2 mmb/d supply addition originally planned will have been returned to the market, is accurate, or that only the initial increment will be added.
Rather than reliving the pain and suffering experienced by the oil industry this year, we will only focus on the most recent events and how they may influence the oil business in 2021 and in the future. While ignoring the question about the health of oil demand next year and long-term, this uncertainty remains a backdrop for much of what will be impacting the industry going forward. Recent events will help shape the industry, regardless of what happens to oil demand.
An aspect of the demand backdrop for the oil and gas industry is the push to reach a net zero emissions target. Whether the push is done via incentives or mandates will prove key to how they impact the oil and gas industry. What these goals do is highlight the eventual peaking in global oil demand, which will appear first in the developed world, and later in the developing world. Those two worlds may diverge sooner than we expect, and the divergence may prove much greater than we anticipate. The divergence will affect energy companies in various ways.
The most visible impact on the industry came via the recent announcements by Exxon Mobil Corp. and Chevron Corp. that each company was reducing its long-term oil price forecast. Those reductions are a directly tied to the slowdown in oil consumption growth. It means the companies are planning to produce less oil and gas, and therefore they will not need to spend as much in finding and developing new reserves. Both oil giants operate with very long-term investment horizons, so making major changes to their assumptions about the future environment in which they will operate is significant. ExxonMobil’s and Chevron’s moves will have repercussions throughout the oil industry, especially for the future volume of work available for the oilfield service industry.
The change in the trajectory of long-term oil and gas prices, coupled with the increased pressure to embrace the green energy movement, has led Denmark to stop offering new licenses in the North Sea and phase out the country’s production by 2050. The announcement was hailed by environmentalists as “what climate leadership looks like,” in hopes other countries, such as the U.K. and Norway, might follow. The move by Denmark marks the start of ending a history extending back for six decades, when the government gave exclusive exploration and drilling rights to A.P. Moller-Maersk A/S. The company subsequently shared these rights with a handful of oil majors such as Chevron and Royal Dutch Shell plc. Last year, Denmark produced 103,000 b/d, or 3.5% of North Sea crude oil output. Even the loss of Denmark’s production today would not have much impact on the global oil market. Thus, the government’s announcement to end its North Sea oil business is really a statement of principle rather than an act with major economic consequences.
A similar event was the announcement by Canada’s Bank of Montreal (BMO) that it is exiting its U.S. oil and gas investment banking and lending businesses. The bank will focus on its oil and gas loans and banking business in Canada, although it is reducing its lending exposure to energy there, also. What we discern from the BMO announcement is that its large loan losses in the U.S. oil and gas business reflects the downturn that has devastated the shale sector. At the end of its fourth fiscal quarter ending November 30, 2020, BMO reported C$457 ($356.7) million of impaired loans to U.S. oil and gas companies compared to only C$93 ($72.6) million to Canadian companies. BMO’s U.S. oil and gas loan book of business was about C$7.0 ($5.5) billion as of July 31, 2020, making up half of its overall oil and gas loans.
While BMO may be adjusting its strategy based on having been burned by its participation in the U.S. energy market, other commercial banks are being pressured by environmental activists and shareholders to stop financing the oil and gas business completely. As we know, the oil and gas business is very capital intensive, especially the shale sector. During the shale boom, securing capital for explorers was relatively easy since investors were actively seeking opportunities to make profits on energy investments to counter the extremely low rates of return offered by bonds and dividends. With the U.S. oil and gas business on a trajectory that would take the nation from being a significant oil and gas importer to a leading exporter, virtually every energy project assumed generating meaningful profits. As we know, when oil prices dropped in 2014, profitability of the shale sector disappeared, and has led to a significant number of bankruptcies.
Environmentalists fighting to end the use of oil and gas detected that the industry was vulnerable with respect to getting production to market. Initially, the battles were fought over the granting of pipeline permits, often resulting in battling over the scope of environmental studies supporting the permit approvals. The most high-profile pipeline battle in recent years involved granting of the cross-border permit allowing construction of the Keystone XL pipeline. Often, even after permits are awarded, environmentalists have fought the actual construction of pipelines, such as the Dakota Access Pipeline project. The pervasive thing is that by blocking pipelines, the safest form of hydrocarbon transportation, companies resort to trains and trucks, which are less safe and more costly.
The environmental movement has now identified access to capital as a key vulnerability of the oil and gas industry. Forcing commercial banks to stop lending money, investment banks to stop raising money in the stock and bond markets, and institutional investment managers to sell their energy debt and equity holdings, are all actions gaining steam, and becoming potentially major hurdles for the oil and gas companies. By attacking the transportation of oil and gas output, along with restricting the funding for finding, developing, and moving fossil fuels, environmentalists hope to slow the growth of the energy business, and pressure the company managements to shift their business strategies away from oil and gas and toward renewable energy projects.
The restructuring of the energy industry is ongoing as bankruptcies continue, although many of these filings are pre-packaged bankruptcies to formalize, under court protection, previously negotiated balance sheet restructurings. At the same time, mergers and acquisitions are driving consolidation, primarily among the smaller companies within various industry segments. We expect both bankruptcies and M&A to continue into next year, which will be an important ingredient in the industry’s restructuring.
The new Biden administration’s financial team will be led by Treasury Secretary-designee Janet Yellen, assuming she is confirmed. Ms. Yellen, former Chair of the Federal Reserve Board and Chair of the White House Council of Economic Advisors, is well-known as a climate hawk. Given her close association with current Chair of the Federal Reserve Board Jerome Powell, the Biden administration is likely to use all its wide-ranging regulatory and oversight powers to push a green agenda on the banking industry. Whether that would extend to encouraging commercial banks to redline certain non-green industries such as oil and gas remains to be seen. This is a reason the Trump administration is pushing regulations to prevent the banking industry from such redlining.
According to reports, Ms. Yellen plans to lead the U.S. into the Network for Greening the Financial System, a 75-member club of central banks focused on climate change. The impact of such a move, combined with the close working relationship with European central banks and governments, may push the regulatory system into requiring a critical assessment of climate risks related to commercial lending, including possibly using the tools of the Federal Reserve. A recent column by Walter Russell Mead in The Wall Street Journal highlighted the potential risks for the economy from such a move.
“Regulating the world’s complex and ever-evolving financial markets is as difficult as it is critical. Adding an extra layer of requirements, even if justifiable on climate-policy grounds, can make it impossible for finance ministers and central bankers to fulfill their essential roles. Not only will climate activists promote mandates with grave and poorly understood economic consequences; special interests will seize a golden opportunity to entrench subsidies and biases into the heart of the financial system.”
One merely thinks of the Law of Unintended Consequences to conjure up scenarios in which businesses are prevented from acting in the best interests of their stakeholders, because of social policies that distort economic realities. While climate will be the initial thrust of Ms. Yellen’s agenda, we fully expect it will be expanded to embrace other social agendas. Deploying the powers of central banks and financial ministries to engineer social change is a primary goal of activists. The risk, as Mr. Mead sees it, was spelled out in his concluding paragraph.
“Massive waves of social regulation proliferating through the world’s financial markets may, in the short term, satisfy activists and allow politicians to bask in their approval. But decades of climate policy failure suggest a new wave of climate-based global financial regulation will most likely do more to slow global growth than the sea’s rise.”
The turmoil that has engulfed the energy industry this year looks like it may moderate as we move into 2021. Don’t be fooled, however, as the winds of change continue to blow, and there are few obstacles preventing them from reshaping significant portions of our federal government, its key agencies, and our international associations. Failure to acknowledge the disastrous social, economic and regulatory policies of the past will be a mistake. We envision that the people who point to them will be waved away as scaremongers or do-nothings. The wisdom of mobs may take us on a journey we currently cannot envision.