Can Oil Explorers Dare to Hope in 2021?

As oil prices continued to rise in early 2021, explorers had to grapple with an unfamiliar and even somewhat bizarre possibility.

Is the business outlook for the oil and gas industry going to be better than almost anyone expected?

Not surprisingly, that idea met with an abundance of caution, and even skepticism, from an industry that experienced the severe downturn of 2014-16 followed by the worldwide COVID pandemic of 2020.

Still, “I think there’s plenty to be excited about, especially given the recent upsurge in oil prices,” said Alex Beeker, principal analyst, corporate analysis in New York City for international research and consultancy group Wood Mackenzie.

Supply Reduced, Demand Steady

Spot prices for West Texas Intermediate crude began to climb out of pandemic-induced lows in May 2020 but seemed stuck in a $40-45 per barrel-range. Then, late in the year, prices rallied above $50.

In the United States, Henry Hub natural gas prices spent the first half of 2020 below $2 per million Btu, then rallied sharply in the second half of the year. However, those higher oil and gas prices did little except put operators back on their feet, Beeker observed.

“Capital is probably not going to be as available to these companies as it has been in the past, so they are going to be forced to live within cash flow,” Beeker said.

“At $50 a barrel WTI, companies are able to reinvest about 80 percent of their operating cash flow, pay down some debt, maybe pay a few dividends,” he added.

But at $50 a barrel “there’s essentially no room for growth,” Beeker noted.

“At $60 a barrel that jumps quite a bit. It probably makes sense to add rigs to grow modestly, and 5 to 10 percent is a number that gets thrown around a lot,” he said.

A decision by OPEC+ to hold production steady and a late-2020 commitment by Saudi Arabia to reduce oil production helped boost world oil prices, said Duane Dickson, vice chairman and U.S. oil, gas and chemicals leader for professional services and consulting firm Deloitte LLC in New York City.

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As oil prices continued to rise in early 2021, explorers had to grapple with an unfamiliar and even somewhat bizarre possibility.

Is the business outlook for the oil and gas industry going to be better than almost anyone expected?

Not surprisingly, that idea met with an abundance of caution, and even skepticism, from an industry that experienced the severe downturn of 2014-16 followed by the worldwide COVID pandemic of 2020.

Still, “I think there’s plenty to be excited about, especially given the recent upsurge in oil prices,” said Alex Beeker, principal analyst, corporate analysis in New York City for international research and consultancy group Wood Mackenzie.

Supply Reduced, Demand Steady

Spot prices for West Texas Intermediate crude began to climb out of pandemic-induced lows in May 2020 but seemed stuck in a $40-45 per barrel-range. Then, late in the year, prices rallied above $50.

In the United States, Henry Hub natural gas prices spent the first half of 2020 below $2 per million Btu, then rallied sharply in the second half of the year. However, those higher oil and gas prices did little except put operators back on their feet, Beeker observed.

“Capital is probably not going to be as available to these companies as it has been in the past, so they are going to be forced to live within cash flow,” Beeker said.

“At $50 a barrel WTI, companies are able to reinvest about 80 percent of their operating cash flow, pay down some debt, maybe pay a few dividends,” he added.

But at $50 a barrel “there’s essentially no room for growth,” Beeker noted.

“At $60 a barrel that jumps quite a bit. It probably makes sense to add rigs to grow modestly, and 5 to 10 percent is a number that gets thrown around a lot,” he said.

A decision by OPEC+ to hold production steady and a late-2020 commitment by Saudi Arabia to reduce oil production helped boost world oil prices, said Duane Dickson, vice chairman and U.S. oil, gas and chemicals leader for professional services and consulting firm Deloitte LLC in New York City.

The Saudi pledge to reduce supplies by 1 million barrels a day “has added to the stubbornness of bulls in the capital and commodities market,” Dickson noted.

“However, the fundamental side of the equation, demand, is not budging much. For example, oil demand remained flat at around 92 million barrels a day in the fourth quarter of 2020 and it is likely to remain under pressure in the first half of 2021,” he said.

Continuing constraints on oil consumption include new lockdowns in large parts of Europe, Dickson said. Road traffic in most parts of Europe dropped by 15-25 percent in early January, he noted.

Despite prospects for a slow recovery in energy demand rather than a resurgence, optimism emerged that the worst of the oil industry’s layoff picture is in the past.

“I do think we’re mostly out of the woods in that part of the equation,” Beeker said.

But he predicted some additional layoffs could occur as companies try to minimize costs, increase efficiency and even build financial strength to take advantage of acquisition opportunities. Could a round of mergers and acquisitions-related layoffs happen in 2021?

“Unfortunately, possibly,” Beeker said.

The tug-of-war between U.S. shale producers and OPEC+ continued to dominate the industry’s business outlook in early 2021, with Saudi Arabia still willing to curb production in hopes of stifling shale development.

“The risk is certainly asymmetric to the downside here. But putting on my optimist’s hat, shale production is obviously a big part of this,” Beeker said.

A stalemate seemed the most likely outcome, with OPEC+ extending production curtailments, U.S. shale producers hoping to avoid a price war and growth possibilities limited.

“We actually predict (U.S.) production declines in 2021, declining by about 400,000 barrels a day,” Beeker said.

Despite recent increases in the active rig count, “we think you would have to add more rigs even for U.S. production to remain flat,” he observed.

Dickson said “the greatest opportunities for U.S. shale companies lie in minimizing natural gas venting and flaring, electrification of fleet and oilfield operations, investing in water-management projects and signing green-power purchase agreements.”

“Fortunately, the U.S. shale industry is living up to this new challenge,” he observed.

Dickson said that in the fourth quarter of last year, the share of gross gas output flared in the Permian Basin plummeted to a modern shale-era record low of 1.6 percent compared to about 4 percent in 2018, according to estimates by Rystad Energy.

“You’ve got a solid decade or more of shale inventory in the United States,” Beeker said, but he sees shale development growth reversing at some point in the future when “you’re spending so much money just in reversing last year’s decline that the U.S. can’t grow production.”

Years of underinvestment have evolved into a potentially serious issue for the industry. In its 2021 industry outlook, Deloitte noted that oil and gas enterprises overall would need to invest more than $525 billion annually just to replace yearly consumption and offset natural field declines.

“Although underinvestment of many years poses risks to supply in the medium term, any near-term recovery in oil prices should be used to prioritize balance sheet strength over growth in the income statement, accelerate decarbonization and digitalization efforts, and capitalize on the next M and A wave” to reach divestment targets and streamline portfolios, he said.

Merger and Acquisition Trends

In terms of future merger and acquisition activity, there’s a disproportionate ratio of sellers to buyers right now in the market but “most companies in a good position to do deals have already done them,” Beeker noted.

However, with improving conditions, “I do think this results in more deals happening, now that we’re seeing positive results,” he added.

“In recent months, the companies helped the most have been those that have suffered most. They might have been seen as being on the brink, but they have now been given a lifeline,” he said.

Companies well-positioned for growth include Pioneer Natural Resources, ConocoPhillips, Devon and Diamondback Energy, all of whom made significant acquisitions in 2020, Beeker said.

In January, Pioneer announced it had completed its previously announced acquisition of Permian Basin-focused Parsley Energy in a for-stock transaction valued at $4.5 billion. Pioneer has been able to refinance some of Parsley’s debt at more favorable terms.

“Basically, that’s going to save Pioneer about $100 million a year, just from refinancing that Parsley debt. That number is actually coming in better than expected,” Beeker said.

Impacts from Energy Transition

Another unknown in the industry’s longer-term business outlook is the future effect of the energy transition and government attempts to address climate change.

“The future of energy relies on and offers a range of decarbonization options, from adhering to foundational health, safety and environmental requirements, to reducing greenhouse-gas emissions per unit of production, to developing a new portfolio of low-carbon fuel mix and energy sources,” Dickson said.

He predicted companies that “deploy and harness the benefits of lean capital and cost structures, dynamic portfolio modeling and risk-management processes, the future of work and greener operations will be best placed to navigate the evolving oil market situation.”

”On the other hand, companies with strategies linked to market cycles, that track their progress against the usual performance levers – reserves, internal rates of return, operating expenses, etc. – and still follow the outdated 2014-15 downturn handbook, will likely remain behind in all oil-price scenarios,” he said.

Proceed Carefully

Despite some optimistic signs, caution is still the rule in the oil and gas industry today. Operators have seen too many setbacks and negative trends in the past half-dozen years.

“One of our biggest takeaways, our biggest lessons from the past year, is that companies are going to be much more cautious than ever before,” Beeker said.

He compared the current situation to the emerging industry optimism four years ago, which turned out to be more of a head-fake than a solid turnaround.

“We encountered this in 2017. It was sort of unfortunate timing, because the Permian Basin was just taking off,” Beeker noted. “Companies have learned from the past, and they’re going to be more cautious going forward.”