Oil Company Executive Reaction When the Commodity Prices Collapse!

Oil industry equipment installation, metal pipes and constructions.
J Reader, President of Barchan Advisory Services Ltd. ©

When oil prices collapse as they have done in the last few months it throws the normal course of business into chaos. This note examines the thinking that is going on within executive teams and boardrooms right now as the industry attempts to adjust to a new, if temporary, reality.Down-cycle corrections usually occur after a period of high and stable pricing. If the industry is profitable at the pre-collapse pricing, then activity levels are high, service companies flourish, and labour is tight. Industry costs tend to be high as a result, and in turn the breakeven price for the industry rises with the cost structure. All resource industry enthusiasts tend to be natural optimists and take the upturns in stride, imagining that the good times will persist.

Oil industry executives of a certain age, however, have seen at least three if not four significant down cycles in their careers and these mentally scarring experiences have had an impact on how companies react to rapid price declines. Reaction is necessary for survival, and some will be too late to respond with inevitable results. The experienced team reacts quickly.

There is really only one lever that the producing company has at hand – costs. The E&P company cannot influence the price other than through commodity hedging programs which in a collapsing market typically reflect an unrealistic future expectation for prices as they are driven by speculation and trading and not by fundamentals. Furthermore, lending capacity is determined by bank price forecasts and if the forward curve is below the bank price deck, layering in hedges will damage the company’s borrowing facility.

Cost control is the mechanism for survival. How is it managed?

Capital First

E&P companies are intended to drill for new reserves. New reserves, connected to new production, first replace the reserves that are being depleted by production, and second grow the underlying value of the company. In an up cycle, cash from the sale of production is supplemented by bank borrowing founded on the growth in reserves, and also by fresh equity injection from investors keen on the sector.In a time of rapid price decline, investors run for cover, and the banks – nervous about the quality of their loans, tighten up their portfolios. At the same time, cash flow declines in response to the falling price on commodities. Furthermore, cash flow doesn’t fall linearly with oil price. It falls faster as margins get squeezed against fixed costs. The need to react accelerates.

Even though companies are typically measured by their production stability and growth, ultimately investors must be shown a full-cycle rate of return of at least 10 – 12%. As prices fall the portfolio of opportunities gets trimmed as ROR’s fail to meet internal metrics. Meanwhile, company treasurers are panicking as their ability to access cash dries up.

The first thing to go is planned capital spending. Numerous capital cuts have been announced in the 2015 New Year. You can bet that organizations are now, or will soon be curtailing their least compelling drilling plays. Other criteria for cutbacks will be timing flexibility due to contract and partner commitments, land tenure pressures, and timing to first production. What is harder to cut are large scale projects with extensive infrastructure which may involve huge momentum and exceptionally high costs or penalties for delay.

It is pretty straightforward to cut out perhaps a third of planned capital spending. The first third probably wasn’t specifically detailed anyway. The next third will involve some serious compromise to long-term value. The last third would signal to investors balance sheet desperation.

Overhead

Much of the head office staff of an oil company is focused on executing the organization’s capital program efficiently. When times are good, there is a need to develop extensive internal processes, organize a large and growing staff, and to develop the narrative of the company for internal and external consumption. Cost control pressure mounts as the cash flow shortfalls are exposed, and in combination with reduced capital budgets leads in turn to a focus on overhead.No management wishes to deal with matters that negatively affect the personnel of their company. For this reason, there is usually a delay time until the need to reduce staff is fully comprehended and then planned for and announced. The delay is a function of both inherent financial flexibility to delay, and organizational culture. Small companies react quickly because the problem faced is immediate. Larger organizations with longer-term vision often wrestle with the issue for an extended period of time, perhaps half a year or more, before acting.

Either way, when the decisions get made they proceed in a more-or-less predictable way. Perks are eliminated first. Next the pressure is brought on consultants, many who are full-time, but easier to deal with, as they haven’t established the employment bond. Finally, the need to release employees is realized. Technical people often run oil companies, so their first targets will be in support services, which, rightly or wrongly, are viewed as parasitic and non-essential. Then core skill-set players who have never been a cultural fit and therefore are viewed as poor performers are identified. As staff counts drop and plays are eliminated from capital programs, certain teams and their middle managers are next. Often there are last minute shuffles made to the organization to preserve critical players who find themselves in the wrong place at the wrong time.

It is very disruptive and costs money to make these changes, so they are typically done in large single events so that there is minimal upset and so the costs can be broken out to investors rather than looking like they are compounding the overhead problem. It is not unheard of that these cuts go too far. Once the decision to cut is made, it is typically addressed with enthusiasm and can be overdone. Sometimes companies subsequently hire back people under contract once they determine that some critical processes are broken from cuts that are too deep.

Services

After capital programs are cut, and while the effort of scrutinizing overhead is taking place, the next focus turns to the costs driven by outside contracts such as drilling and completions, construction, maintenance, and product supply. These are harder to properly assess and take longer to act upon.The difficulty in assessment results in part from the need to maintain safe and regulatory compliant operations. There are many costs incurred by E&P organizations that driven by the inherent danger of the petroleum extraction business. Operators are reluctant to arbitrarily push overly hard on these costs for fear that safety protocols could be breached, safety culture undermined, and equipment fail resulting in very negative outcomes such as death and severe environmental damage. Therefore, it takes time and careful technical consideration to proceed on this front.

It also takes time due to contractual commitments with suppliers that have to expire before re-negotiation can occur. Rig contracts, completion crew contracts, and so on often have lengthy terms some extending over multiple years. Where service suppliers do not have long-term commitments, they will see their work in these areas come to a rapid halt. This is why service companies are faster at showing the signs of a downturn and announcing layoffs. They can see work stop in a matter of days and weeks, and their business does not rely on a long term, in-ground reserve to produce some cash. When the rig is released and laid down for an extended time, its crew is no longer needed and is furloughed.

The gradual effect of an extended downturn is a complete re-adjustment of industry costs in order to preserve some level of profitability. It can’t happen overnight, but it will eventually result in a change to everyday wage expectations over a broad range of service industries.

Dividends

Return of cash to investors is unrelated to the business of finding and producing oil. However, it is vitally important to credibility with investors. When a fight for survival looms, even the dividend must be addressed to preserve cash. Smaller organizations react first out of need. Larger firms will try and maintain their dividend policy for as long as possible, even to the point of selling assets or increasing debt.

The Need for Speed

As 2015 progresses into a deeper and longer down-cycle, watch for the evolution of cost cutting as described above. One common mistake of management teams is to react too slowly and with insufficient magnitude to the need for change. Well-prepared teams react quickly to the changing requirements of the business. Less experienced teams can find themselves in extended periods of denial which will fritter away at financial flexibility and leave the company is poor shape to weather the storm. It also happens that some management teams will find themselves reacting to the direct instructions of their board of directors, or in the worse-case scenario to the orders of their banks or the bankruptcy court.Denial occurs because there is nothing personally rewarding about dealing with the very real human aspects of organizational change resulting from cost cutting. No executive relishes the idea of letting people go, or of damaging a corporate culture carefully nurtured and viewed as a personal success. However, these types of cuts are necessary to preserve the integrity of companies in times of severe down cycles. Management can only take satisfaction in making the difficult decisions in a timely way and with maximum respect and responsibility for all the stakeholders – investors, lenders, employees and service provider alike.

 

“Oil Company Executive Reaction When the Commodity Prices Collapse.” in PDF

 


Copyright © Barchan Advisory Services Ltd. 2016

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