7 minute read 2 Apr 2020
Business woman study financial market

Five crisis responses in the pipeline for oil and gas companies

By Andy Brogan

EY Global Oil & Gas Leader

Oil & Gas sector leader, speaker and industry advocate, optimist, music addict and avid traveler.

7 minute read 2 Apr 2020
Related topics COVID-19 Oil and gas Strategy

With demand growth likely to be flat for the rest of 2020, oil and gas companies need to be thinking survival first.

I’ve been thinking about the recent upheaval in oil markets, what was behind them and how the situation might resolve itself. It’s obvious that current oil prices won’t support the marginal barrel – the “extra barrel” that sets the global price. It might take a while for the marginal barrel to matter very much. Demand growth will (at best) be at a standstill for the rest of this year, and the low-cost producers are rather volubly targeting volumes and not price support at the moment.

Access to capital will be severely restricted and producers will likely only be able to invest the cash they generate. Capital expenditure and exploration will be (and already has been) scaled down dramatically, perhaps more than many are saying or any of us expect. While eventually economic realities will take us back to something like normal, no one knows how long it will take.

As always, there’s a risk of overreaction, of hitting the brakes too hard on investment and not being ready when things do turn around.  However, to have a chance to profit from the recovery, companies need to survive. This means they need to make the most out of the capital they have. With that in mind, in addition to the direct crisis response activities that have been rolled out across the sector, here are five commercial responses we’re seeing.

1. Manage liquidity

Survival is the first priority, and in the current environment business survival means liquidity. We have already seen companies focusing on short-term cash forecasting with a much more aggressive focus on working capital and liquidity management. This focus is likely to continue for the foreseeable future, though over time we would expect it to move from being labor-intensive to more process-driven, digitized and automated.

Survival is the first priority, and in the current environment business survival means liquidity.

More heavily leveraged companies have already started engaging with their debt providers. Creditors will have limited capacity themselves to absorb losses and the companies that approach them first with the most realistic plans are likely get the best deal. Beginning a proactive dialogue with creditors about potential debt restructuring now makes sense in these circumstances.

2. Cut costs and capital expenditure

You might think that everything that could be done was done during the last downturn. However, digitalization technology has moved on substantially from where it was then, and there is now another population of cost-reducing activities available. These often do involve a significant amount of organizational change, which may have deterred implementation up to now. However, in the current situation this resistance has evaporated.

We see great potential for quick wins in tools that create a “single source of truth” across the oil and gas value chain. Inefficiencies creep in when there are uncertainties about exactly what the facts are or when there is unnecessary cost or time involved in communicating information across the organization. That principle is especially important in complex processes such as well planning, maintenance scheduling and crude, product, gas and derivative trading.

Complex supply chains are also particularly interesting targets for digitalization and data analytics. Having the right piece of equipment or material at exactly the right place at exactly the right time is a science that requires investment and practice but will pay back big and quickly.

In addition, capital scarcity makes fixed costs and one-time investments, no matter how economic or beneficial, problematic. Many oil and gas companies still have the potential to turn fixed costs into variable costs with shared services, management and outsourcing solutions.

3. Consolidate

Not every company will survive this cycle. We know the market is overcapitalized in the aggregate, and there are two ways to improve economics in that type of environment: reduce capacity and/or competition and reduce costs. Access to financing and the need to restructure debt will turn up the urgency on the next wave of consolidation.

Any consolidation process begins with a surveillance process and this has already begun. Who has the higher cost structure? Where’s the synergy with the various bits and pieces of acquisition or merger targets? How does it fit with what is already owned and how does a target’s portfolio complement or fill gaps? This time we expect capital providers to be ruthless in questioning if they are the best owner of the assets they operate and to be much more dispassionate in reviewing consolidation options.

4. Protect the revenue streams

Every market dislocation creates a winner and a loser in long-term contracts, and the losers will be eager to find a way to rework those contracts. LNG contracts have already become prime targets for renegotiation and sometimes the mere threat of arbitration is enough to encourage the party on the right side of the deal to come to the table. We have seen enough already to believe that every material contract will be the subject of discussion in the months to come. The best defense here might be a good offense. Start the process knowing in advance where the rest of the market is, what you can afford to do, what your competitors might do and what your counterparty thinks they can get elsewhere.

5. Monetize volatility

No one knows how all of this is going to turn out. In the time it takes this cycle to play out, there will almost certainly be feints toward recovery and temporary setbacks. That’s the way commodity markets work. Companies in our industry are used to that, but our customers aren’t necessarily.

In addition to trading opportunities that have been present in abundance for the last two weeks, volatility creates at least two other opportunities. Companies can make a market, simultaneously buying and selling a commodity to less informed and connected players, earning a bid-offer spread. Companies can also offer complex risk-management products to commodity consumers or producers with less developed capabilities. They can either warehouse those risks or hedge them opportunistically, again earning a margin. As running those types of businesses successfully requires at the very minimum 1) the ability to sweep up and process large volumes of market information and 2) the capacity to measure and control risks in a very sophisticated way, only those with mature and scaled trading functions will fully be able to take advantage of this market opportunity. However, whether and how to engage with these players will be a question everyone needs to answer.

Supply chains should brace for impact

Service companies will be hit particularly hard in this downturn. They’ve never really recovered from the previous one and the underlying conditions (oversupply and market fragmentation) are still there. The same bits of advice hold for them, with increased urgency and a few twists.

There was an expectation of a wave of consolidation in the wake of the last downturn that never materialized. This time, financial necessity might force the issue, and consolidation might go hand in hand with financial restructuring. This time, capacity really does need to be removed from the market. The imperative to make costs variable will be especially important as cash becomes scarce. Lastly, service companies will need to focus their capital on parts of the world where there is the least risk of projects not moving forward. That means low costs and short lead times.

It is going to be bumpy for the next few quarters, and it looks like the industry will finish the transformation it started last time. However, the world’s medium-term energy requirements and energy mix are (at the moment) going to look similar to how they did coming into this downturn, so eventually a return to a more “normal” market driven by fundamentals will happen.

Summary

There won’t be a “normal” oil market for a while, and the road to recovery will be bumpy. To absorb the shocks, companies should be taking the necessary steps to survive – now.

About this article

By Andy Brogan

EY Global Oil & Gas Leader

Oil & Gas sector leader, speaker and industry advocate, optimist, music addict and avid traveler.

Related topics COVID-19 Oil and gas Strategy