Journally Speaking: Downstream survival

Nov. 2, 2020

Prior to the COVID-19 pandemic, the view of the future for North America’s downstream oil and gas industry was that of robust margins, a resilient economy, and strong demand. The US downstream sector “managed to outperform similar industries in total value creation over 10 years and even as far back as the early 1990s,” McKinsey & Co. said in a September insight. However, the industry was ill-equipped when the global pandemic hit. Non-OPEC oil exporting countries overproduced and oil prices crumbled to historic lows, demand for transportation fuels came to a halt, and available storage was nonexistent, forcing refiners to reduce output. The oil and gas industry has previously experienced hard economic times and recovered, but the year’s events are alarming and unprecedented.

For downstream companies to survive the pandemic, they will have to fundamentally renovate themselves, McKinsey said, noting “those that succeed will shape the industry’s future; those that fail will become consolidation targets. Even among companies ultimately acquired, there is an important benefit to getting as far down the path of transformation as possible. The further they progress, the higher their valuations will be.”

To survive during and after COVID-19, with continuing growth, companies must understand market insights with strong tactical ideas. According to McKinsey, there are five structural challenges that must be accounted for when adapting and succeeding in this unpredictable market:

  • Oceans of inventory. COVID-19 shut down a market infrastructure like never before. The overabundance of crude oil and products led to no storage availability and pipelines couldn’t move product, which led to prices plummeting. Lesson learned here is keeping check on supply from OPEC-plus countries that could substantially burden the market leading to price instability.
  • License-to-operate costs. High cost to operate continues to be the norm. Regulatory compliance has tripled since the late 1990s. “At the same time, companies are facing an increasingly litigious culture, divided political agendas, and a rise in activism that targets ‘big oil’ and manufacturing.”
  • Paradigm shift in demand. Since COVID-19 with people sheltering in place and working from home, demand for transportation fuels went down. Telecommuting for employees proved successful for businesses and this will have a long-term effect on demand for gasoline. Airlines will continue to suffer the effects of COVID-19 for the next couple of years.
  • Change in product mix. Refiners must change their focus of their product line to diesel and gasoline through 2021 to equalize product demand. Jet fuel will take a back burner. This will impact profitability as well as fluctuation in crude-quality disparities.
  • Crude-price instability. Alliances among oil producing countries are few and far between as countries will look out for their own balance sheets. Mexico, Russia, and Saudi Arabia exemplified the grim task of unifying production cuts needed to calm the markets at the beginning of the pandemic.

McKinsey & Co.’s understanding of the downstream energy sector suggests a three-phase comeback for successfully responding to what happened during the pandemic. Phase one suggests “readjusting” by reserving cash until the market turns around. “They should exercise the full set of cash-management levers, including reducing inventory positions, lengthening suppliers’ payment terms, reducing receivables terms, deferring capital expenditures, and halting equity disbursements,” McKinsey said.

Phase two is to “reimagine” by reducing general and administrative costs while introducing operational improvements and reassessing supply chain and procurement and optimizing trading capabilities.

The final phase is to “reform,” McKinsey said. Downstream companies should reform to realize achievement by introducing functional-support delivery and new technology. Companies must overhaul forecasting and planning to make sound investment decisions and reassess portfolio strategies.

The sector’s companies must operate in a different world than they did prior to COVID-19. According to McKinsey, “those that succeed will shape the industry’s future; those that don’t will not survive to tell the tale.”