WoodMac: Upstream sector survival mode

The oil and gas sector is in survival mode given the coronavirus outbreak has derailed OPEC+, thrown the oil market into turmoil, and sent the sector into freefall—all setting in motion a chain of events that led to the steepest oil price drop in 30 years, said Wood Mackenzie in a recent report. The long-term impact on demand and commodity prices is unclear, but current prices are bleak news for the industry.

Upstream spending

“Even if OPEC+ returns to the table and comes to a new agreement, recent events have irreversibly changed perception of risk. The genie will not be put back in the bottle,” WoodMac said.

The upstream oil and gas sector faces unprecedented uncertainty. The range of outcomes for investment is very wide, but it is clear oil companies must act quickly. There are strong parallels to 2015-16, but the macro-environment is different.

Immediate and deep cuts to discretionary investment will be the industry’s first response. Global spend could fall well over 25% year-on-year, an estimate that will change as more data becomes available.

Companies’ main levers to cut expenditures include: (1) Drive efficiencies to extract the same or similar production for lower investment; (2) Defer the sanction (FID) of new projects; (3) Reduce activity levels and costs in the base business (including short-cycle investment, exploration and operating costs).

Large new projects will be put on hold and short-cycle discretionary investment will be dialed back to the bare minimum. Spend on projects under development and onstream will also be targeted. Exploration will be trimmed; operating and other fixed costs face intense scrutiny.

Only the lowest-cost producers with the strongest finances will be in a position to make meaningful discretionary investments. Any decision to follow Saudi and Russia and grow output will likely be driven by policy rather than economics, according to WoodMac.

Productions

“If prices do not rebound quickly, we’ll see a significant impact on currently producing fields and future supply.”

Analysts calculated global short run marginal costs (SRMC – operating costs + taxes and royalties) for current production, at the asset level, using the Wood Mackenzie Lens platform. At a Brent price of $35/bbl, revenue from 4 million b/d (4%) of global liquids supply does not cover production costs and government share. This rises to 10 million b/d (9%) if prices fall to $25/bbl.

“In the last downturn in 2015-16 virtually no out-of-the money production was shut-in, even at the highest cost wedges. The associated costs are too high. But prices only dipped below $45/bbl for a year, and below $35/bbl for one quarter. There is no precedent for the scale of potential shut-ins, if there is a prolonged period of low prices, for today’s asset classes.”

 The industry’s ability to keep higher cost barrels flowing will be tested. Longer-term, the impact of a lack of spend on maintaining existing production and capital spend to replace declines will take over as the primary driver of supply.

Core producers Saudi Arabia, Russia, and the US need to continue drilling wells to maintain production levels. But whereas the Saudi and Russian governments decide their own investment and production levels, the US government does not. Individual company strategies fill that role. Those same companies were challenged financially even before the price fell.

 In the short term, companies, governments, and other stakeholders are likely to continue producing assets at a loss, as they have in the past, in the hope the price will rebound quickly. But, the current trifecta of oversupply, demand evaporation, and global behemoths fighting for market share may require immediate and dramatic action, WoodMac said.

Just as companies rush to stem the cash hemorrhage, petro-economies may have to act to avoid steep climbs in budget deficits. Paradoxically, where a high proportion of an asset’s production costs are fixed – think facilities running costs, materials, rent, compliance, and so on – the easiest way to reduce unit operating costs is to increase production, if that is an option.

If prices don’t rebound, the taps will inevitably be turned off, WoodMac said. Shut-ins will be more substantial than 2015-16. Given the difficulties and costs associated with restarting mature production, a proportion of this supply may never return.

Upstream service sector

“If operators hurt, the supply chain will feel it too – possibly more so.

Coming into 2020, the service sector had been struggling with low margins, over-supply, and weak investor sentiment. Any optimism regarding 2020 upstream project execution activity, prior to the oil price crash, has been unequivocally reversed.

There are three themes that operators, OFS companies, and their investors will have front of mind.

First, equipment and services demand. Even more capital discipline from operators will reduce demand in a big way in 2020. Whether offshore or in the Lower 48, only a handful of major projects are expected to move forward this year.

Second, financial resilience. Stretched balance sheets and low margins were still commonplace for the service sector coming into 2020. Companies had already cut so much, it’s hard to identify further savings without drastic measures. This includes refinancing and the restructuring of business models. Headcount cuts and bankruptcies are inevitable.

And finally, excess capacity. Companies holding onto idle assets “just in case” will quickly think again.

According to WoodMac, the prospect of sub-$40/bbl oil will be enough to force profound change in the sector’s footprint. While there’s undoubted short-term pain associated with this, it could ultimately create a more sustainable business for those that survive the downturn.

“Once upstream activity does pick up – whenever that is – the reality of a much smaller and less capable service sector could cause headaches for operators. The elasticity to bounce back quickly may not be there. The strongest service companies will drive collaboration and technology development. A smaller and more efficient industry awaits,” said WoodMac.