Market conditions reshape business and M&A strategies in oil and gas

Demand shock, combined with a supply discipline dispute, puts oil and gas on a long road to recovery post-pandemic.

The COVID-19 pandemic, which first affected the Asia-Pacific region in the early part of 2020, brought much of the world to a sudden halt from late February. Mobility and advanced manufacturing, key end use sectors for oil and gas, were seen to be among the most-affected sectors, according to the latest EY Global Capital Confidence Barometer (pdf). Oil and gas demand has therefore been affected by the dramatic decline in travel and the shuttering of factories, as countries work to contain the spread of the COVID-19 pandemic.

Based on the increasing impact of the pandemic, the IMF has forecast the global economy to contract by 3% in 2020. If accurate, this would be the largest economic contraction since the Great Depression. In addition, according to a recent International Energy Agency (IEA) Global Energy Review report, as a result of declines in mobility (air and road), global oil demand in March dropped by a record 10,800 mb/day year-on-year. In the second quarter of 2020, the IEA is projecting demand to be 23,100 mb/day lower than 2019 levels.

An oversupplied oil market depresses market confidence

The results of our survey reflect a clear shift in business sentiment between early February, when the survey began, and late March, when it ended. Prior to mid-February, outside of Asia-Pacific, a clear majority of respondents felt confident about the global economic outlook. This sentiment diminished considerably after 19 February 2020.

A sharp drop in global oil demand caused oil markets to be oversupplied; as a result, oil prices continue to be weak and extremely volatile. The failure of the OPEC+ deal in early March caused them to fall by US$25/barrel in a single day and significantly dampened market sentiment. Prices were later supported by an OPEC+ deal to cut 10% of global oil output — probably the largest cut in history, but still not considered enough to compensate for the lost demand. More recently, US oil (WTI) prices fell below zero for the first time ever, as traders paid to sell contracts that might have required them to make physical deliveries when there was no storage available. International crude prices followed suit, dropping to multiyear lows.

As a result, 83% of oil and gas executives surveyed expect the COVID-19 pandemic to have a major near-term impact on the global economy; 68% anticipated a U-shaped or L-shaped recovery, with slower or recessionary economic activity extending at least into 2021 or 2022. Oil and gas respondents were also less optimistic compared with other sectors, given the current situation. The uncertainty now revolves around how long it will take for demand to recover and how the recovery will unfold, based on regions and demand segments. The prevailing global sentiment suggests that the global economy will experience a seesaw recovery, reflecting the absence of an effective vaccine and the possibility of recurring outbreaks and extended lockdowns.

Next, oil and gas companies need to transform their business for resilience

Our survey results show that nearly 60% of oil and gas companies have increased their margins over the past two years through improved pricing, efficiency and use of technology. As the industry continues to evolve, they need to accelerate steps to re-evaluate their operations and strategy, increase digitization and move further away from bespoke engineering toward commoditized processes. The industry will be more efficient and resilient in 2021 than it was in 2019; it will be slightly smaller, but more focused on prospective assets, and the way that companies operate them will be quite different.

Some of the 70% of oil and gas companies that say they are currently undergoing a significant business or technology transformation program may be tempted to put the program on hold, as they address more pressing concerns around liquidity and cash flow. Although it may feel counterintuitive, they may find that accelerating transformation efforts will help them address their people, liquidity and technology issues, without significant layoffs or fire sales of distressed assets.

Looking beyond, long-term-value creation and decarbonization will drive capital investment

Oil and gas executives need to keep their sights trained on their longer-term vision. Once they have addressed the immediate issues and embarked on planning for what comes next, executives will want to turn their attention to more long-term, potentially existential, issues such as decarbonization, the energy transition and long-term-value creation, including the social impact.

Climate change and the urgency to do something about it will not go away. As the COVID-19 pandemic passes, there will be outstanding questions related to who — governments, companies or consumers — will make the required investments in fossil fuel alternatives, how they will be incentivized and when they will be made. There will be continuing pressure on oil companies to reallocate capital on the basis of climate impact, and fossil fuel investments will be increasingly scrutinized on the basis of sustainability and carbon intensity. We expect these strategic imperatives to drive capital investments, including M&A activity, over the medium-to-long-term.

Oil and gas companies must be resilient as they reposition for the “new normal”

The immediate and abrupt reduction in oil and gas demand — and the resulting shock to the economy — has raised some long-standing issues that have made balance in petroleum markets precarious at best. While the recent agreement with OPEC+ to lower production is a positive step in addressing supply, absent a quick recovery in demand and a more long-standing and stable production discipline agreement among major oil producers, the oil and gas market may be waiting years, rather than months, to rebalance. These are the conditions under which oil and gas companies should prepare for resilience.

As oil and gas companies reposition for the new normal, they should continue to be open to new ways of doing business. As employees find new ways to work, companies will want to consider the positive impact these shifts in behavioral trends may have as they look to reimagine more cost-efficient and digitally enabled operations in a post-pandemic world.