Emerging Trends for 2016

Oil gas processing plant with pipe line valves
J. F. Reader & S. A. Reader, Barchan Advisory Services Ltd. ©

Barchan received feedback from clients and others respecting its price outlook for 2016 and here we address some of that feedback with additional thoughts. We are chagrined to note that our anticipation of sub-$30 oil has already arrived and we are still only in January. Here we expand our thinking by sketching some emerging trends to watch for over the next year or so. In particular, we include a few comments on the potential impact of global politics on prices.

Industry responses to global pricing

Producers
The shake out of global producers will accelerate and continue through 2016. Much of the growth of North American upstream companies in the last decade has been funded by sources of external capital, including a substantial amount of debt. Money has been readily available and inexpensive. Going forward companies will have to rely primarily on their own cash flow for capital programs. Due to the high declines in the unconventional plays, and the low commodity price environment, these cash flows are very low.

The consequences will be continued reduction in dividends, reduced drilling activity, production declines, mergers of quality companies, and insolvency for others. There will be less employment and a focus on cost reduction in addition to what we have already seen.

Many anticipate a wave of upstream consolidation aimed at strengthening the best players and reducing costs. So far, the wave has proved elusive. The main reason is that the outlook is so bleak that very few plays or assets are attractive at any price. We view that only select, high quality deals, typically on the larger scale will be seen in the next year. Many smaller, stressed-condition deals will continue to go no bid, leaving the future of many companies in question.

For national oil companies and the countries that rely on petroleum revenues, there will be large deficits ahead and the potential for social unrest – even to the point of revolution. There is a small possibility that OPEC may come to a production reduction consensus, but Barchan views this as unlikely.

Service Companies
The service sector has been brutalized over the last year. As the work dries up the cash flow goes to near zero. Sophisticated equipment such as automated drilling rigs, offshore drill ships and so on, become worthless assets. These firms have no ability to continue to employ their field staff, and these folks are immediately out of work.

All this has played out dramatically in 2015, and the future of this sector is very much in question for 2016. Barchan is aware of equipment that was hard at work in 2014 being sold for scrap metal value over the last half of 2015. This is what happens when more than half the North American rig fleet is laid down in short order. Most large players with international operations have relied on the more active overseas environment to sustain their businesses. Domestic-only players are very stressed. We believe that even the international players will feel the pinch in the next year as the reality of low prices begins to impact even the sovereign players.

Midstreamers and Pipeliners
In the high price cycle, parties in between the producer and the consumer jumped on infrastructure development to de-bottleneck older systems. These are now overbuilt for the foreseeable future and although these firms will carry on, their returns will be far less than predicted. The rush to get new basin crude to tidewater via new pipeline development is now over. We believe that none of the inter-jurisdictional pipeline projects within and from Canada will be sanctioned in the next five years.

Capital Markets and Lenders

Equity
It is hard to imagine much free-market, equity investor interest in the energy sector in 2016. Investors have abandoned the junior and mid-sized sector and Barchan sees no change next year. There was a flurry of interest when prices recovered slightly last June, but subsequent commodity price slumps and growing inventories have doused any continuing enthusiasm.

Some long-term players, typically from offshore locations are stepping up, but the deals that they are prepared to strike are understandably on very hard terms. These deals are difficult to close and time consuming. North American governments will scrutinize large-scale deals of this nature if they start to look too aggressive.

Some very astute equity players are now starting to position for building new companies from the best of the wreckage wrought in the downturn. Picking the best assets and having patience will pay off for these investors, but the timing of that pay off may be two or three years out.

Debt
Our view is that the banking sector is going to be where the main action will be in 2016. A confluence of factors meets up during the year: spring borrowing-base reviews under very depressed price outlooks compounded by high production decline rates, a continuing wave of broken cash flow covenants, a stalled out asset transaction market, and an increase in interest rates.

Just as equity players are walking on the sector, bankers will follow suit. However, their exit will be quite painful as loans go bad and company boards start throwing the keys to their bankers. During 2015 managements and boards pulled every lever at their disposal to improve their financial condition. This year there are few, if any levers left to pull. We see an accelerating trend towards restructuring of heavily levered companies in North America.

The impact on the energy sector of a wave of bad loans is hard to assess. In the mid-1980’s a number of banks went under, and many large players were severely compromised when the energy sector experienced a price-related collapse after a sustained period of elevated commodity prices. Could the same be in store this year? – it’s a definite possibility. Watch for increasing sector bankruptcies and banks failing stress tests. Either way, loans to energy companies are going to be much harder to get and also more expensive going forward, due to risk perceptions and fiscal tightening by central banks.

Other Trends to Think About

Abandonment Liabilities
As energy companies go out of business, there is a significant risk of a wave of unmanaged abandonment and reclamation liabilities – so-called ‘orphans’. Companies make rational assumptions about the timing and cost of the end of life retirement of their assets, but the funding of these relies on sufficient cash flow to pay for them. When prices fall precipitously, suddenly assets that were profitably producing become uneconomic, and yet there is no ability to commence abandonment.

This situation is first a problem for managements to deal with, but can rapidly develop to become a problem for the oil and gas regulator and for society in general. Strong enforcement action by regulators has the effect of accelerating the demise of previously solid producing fields.

Climate Change Initiatives
Society becomes highly aware of the sustainability question when energy commodities are high priced. High prices however, should limit energy use and improve the problems associated with CO2 emissions. A battery of new initiatives aimed at taxing energy use are bound to further delay any recovery of the industry from its current woes.

Regardless of what people think and the media portrays, the fact is that about 75% of the carbon emitted by the use of petroleum products is at the point of use by the consumer. If there is a collective desire to curtail carbon consumption, it has to be made expensive to use. It is as simple as that. Taxing the industry rather than the end user is wrong headed and leads directly to increased job losses.

Barchan predicts that the pressure to curtail carbon use will taper off now that oil and gas prices have fallen to lows not seen in the last decade and a half. We also believe that governments in oil producing regions will have a tough time applying new taxes to an industry that is under such stress and that employs a lot of voters. Watch for ‘go slow’ action on climate change policy in 2016 and 2017.

Generational Turnover – the Baby Boomers Retire
The generation that drove the industry forward since the last phase of high prices are of an age where, if they lose their jobs now they will likely just retire. This will result in significant expertise leaving the business. After the mid-80’s industry downturn, new recruits to the business disappeared for about 20 years. Some well-known universities closed their petroleum engineering departments, never to open again. This created a demographic hole of considerable concern to companies. In a downturn no one worries about less people, but when the recovery comes, especially if it is rapid, there will be stress on organizations trying to staff to meet their growth objectives. These stresses result in economic inefficiency as well as safety issues as old mistakes are repeated through inexperience.

Global Politics and the Potential Impact on the Energy Business

Barchan received a lot of feedback respecting its 2016 Energy Outlook noting the absence of predictions respecting political impacts on the business, notably returning Iranian production and the claim that Saudi Arabia is trying to regain market share. The difficulty with politics and politically driven decision-making is that it is arbitrary and non-correlatable with things that can be measured. In fact, much political decision-making is erratic and generally poorly informed by facts. Political influences are similar to speculation and we do not believe that trends caused by these non-fundamental factors can be particularly long-lived.

For example, it is common to read that the Saudis are attempting to regain market share through a policy of increased production that is driving prices lower. Supposing this true, how long can a single player keep up a strategy like this? In the 1970’s an embargo driven by the Saudis caused a couple of price shocks with duration of about 1-2 years each. Fundamentally, the impact of the embargo was not sustainable and market forces overwhelmed it.

In the present circumstances, the argument about market share makes no sense. A rational producer would rather produce less at a higher price, than more at a lower price because the cost of replacing production is always higher when dealing with a depleting resource. This is not to say that such a strategy might seem politically forceful, despite being economically ill advised. Therein lies the problem with forecasting politically motivated changes to the market – they are not necessarily rational and regardless will eventually be overwhelmed by market forces.

Concluding Remarks

There are comparisons being made between the current downward price cycle and that of the 1980’s. While the price movement bears comparison, the world dynamics are very different. The rising prices of the 1970’s followed by the price collapse in the 1980’s were driven by a fundamental change in the demand side of the equation, whereas todays price collapse results largely from a supply challenge rather than collapsing demand.

The energy end-users that dictate demand growth today are completely different from the previous cycle. The world population has nearly doubled, but the so-called developed population has hardly changed. In the 1980’s the world economy was driven largely by the US and Europe. Today, the world continues to grow and is evolving a global middle class of large proportions.

In the 1970’s OPEC had a tremendous hammer as the swing supplier for western consumption. Today, the strength of OPEC is curtailed with its principle member economies in a shambles. Consumers will be quite pleased to use up the cheap conventional resources of OPEC if producers are willing to sell below the cost of replacement.

The advent of a western fuel efficiency drive, particularly in automobiles after the Saudi embargo in the 1970’s created a permanent technology-driven demand change that lasted twenty years until global growth caught up with available supply. Today, growth in global population and economies is overwhelming the demand-side energy efficiency drive.

In the current cycle, the high price environment over the past number of years has spurred technology development within the industry that has unlocked the vast unconventional resources of North America. This has led to excess supply that has precipitated the price collapse. The question remaining now is how long will it take before the industry finds a more reasonable balance between supply and demand?

There is no doubt that the current downturn is more severe and lengthier than anything that has been seen in the last thirty years, but it is unlikely to last. The world needs hydrocarbons to grow and thrive, and eventually, demand will soak up available inventory. Barchan sees this as a 3-5 year cycle to recover to a better balance between supply and demand. The industry will carry on, but the depth of this downturn will definitely have some lasting consequences that create permanent changes.


Copyright © Barchan Advisory Services Ltd. 2016

DON’T MISS AN UPDATE

Subscribe to our mailing list for regular delivery of valuable thought leadership