2016: A Year of Transition
From 2005 to 2014, oil and gas company stocks collectively outperformed the market by a factor of 1.3–2.0x (figure 1).1 Fueled first by high natural gas and then oil prices, activity soared; and companies across the entire value chain enjoyed the boom in drilling and the resulting midstream and downstream projects. Now the global oil and gas industry is in the midst of one of the severest downturns in 30 years. Industry revenue for 2015 is estimated at 10 to 20% below that for 2014, with industry profits expected to shrink by 20 to 30%. That declining trajectory seems likely to continue in 2016.
Even worse, return on capital employed is expected to fall to around 3% in 2015—a far cry from the better-than-20% returns of 2005 and 2006. That eroding return comes from falling commodity prices driven by a global oversupply of oil and natural gas, increased spending on more-complex, capital intensive projects, and the impact of higher industry debt levels after companies levered up to finance their pursuit of growth.
Companies that aggressively adjust their business models, lower their break-even costs, instill the necessary capital discipline, and develop innovative ways of working with suppliers and partners will likely survive this year; and they’ll even thrive if they execute comprehensive retrenchments. However, others will be forced to part with key assets, or become acquired by competitors, or face bankruptcy. The projected revenues of 134 North American–based E&P companies show there could be a gap of $102 billion against their operating and capital expenditures in 2016, signaling a need for major financial and operational adjustments. There’s already early evidence of such outcomes for players across the value chain.
Many upstream companies have identified their noncore asset positions, and they’re now trying to divest those positions to raise cash; several smaller E&P companies have filed for bankruptcy. Most of the OFSE players are refining their geographic footprints and service offerings by closing unprofitable field locations and discontinuing product lines to conserve cash. The industry already cut well over 200,000 jobs in the past 18 months, and several large-scale mergers were designed explicitly to wring out even more synergies. We expect the paces of those types of activities to pick up in 2016 because current industry dynamics appear geared to a lengthier slump than previous cycles lasted.
The industry playbook is expected to include continuations of some or all of the following measures.
- Cutting capital expenditures (capex) spend by 30 to 50%
- Stopping or scaling back share buyback programs and dividends
- Divesting assets to high-grade the portfolio of underperforming operating positions
- Aggressively renegotiating contracts at price points 20 to 30% lower, often to the point of break-even for the OFSE supplier
- Going beyond large-scale layoffs—including implementing wage freeze or in some cases, even wage cuts—to reduce labor costs
With those trends in mind, we next take a closer look at what’s happening in key sectors across the oil and gas industry.
E&P: Retrenching to the core
The rapid collapse in commodity prices in 2014 triggered a near immediate response from industry participants, which continues to reverberate in early 2016. Starting in late 2014 and continuing throughout 2015, upstream companies reduced dividends, cut or eliminated share buybacks, implemented supplier rate reductions, reduced capital spending by 20 to 40% (figure 2), and imposed staff reductions—or at least hiring and salary freezes. Drilling activity in the United States declined by more than 50% in the past 12 months.
Early actions by companies across the value chain enabled those companies to lower break-even costs across active basins in the United States by 30% or more, which should make 2016 an easier year for them. Those companies aggressively reset their cost structures with suppliers; took organizational actions to realign their general and administrative expenses (G&A), with new, lower levels of activity; and immediately began high-grading their drilling portfolios. Those actions enabled many companies to continue to operate selectively within the core areas of their acreage, where the development economics are still attractive. Those measures should serve as a roadmap for other players that face continuing challenges (figure 3).
In total, we estimate that overall capital spending by public companies worldwide declined by nearly 20% in 2015 from record 2014 levels, with the E&P sector declining by more than 30%. Capital spending reductions by upstream producers are expected to continue this year, which will help rebalance supply and demand and eventually help boost commodity prices. In the short term, however, spending reductions will have a pronounced, negative impact on the oil field services and equipment sector and require even more aggressive cost reductions.
Meanwhile, oil and gas M&A activity in the first half of 2015 dropped to a multiyear low (figure 4) as buyers and sellers struggled with asset valuations in a volatile pricing environment. However, US E&P operators with high debt and large impairments will likely have to resort to asset sales as access to capital recedes.
Looking to 2016, we expect the start of a slow and steady recovery in prices, driven by global supply-and-demand dynamics. Transportation fuel demand—particularly caused by growth in developing economies—is largely responsible for sustaining global oil demand and for generating only minimal growth in some markets.
Nominal supply increases are expected through 2018, which will prompt a slow and steady recovery in WTI prices. OPEC is expected to continue to maintain its global share based on its resource and cost advantage (figure 5).
US shale has the advantage of lower and shorter investment cycles compared with conventional oil, which makes US shale more responsive to oil prices. Taken together with the lower break-even point for shale resources—thanks to cost reductions and productivity enhancements—the United States has in effect become the global swing producer.
Any significant oil price upside may be capped by the availability and responsiveness of US shale development and could keep oil prices range in the area of $45 to $65 per barrel for the next several years. Weekly US oil production began to decline in June 2015 after having grown at a compound annual growth rate of 11% since 2010. Reduced rig activity means production is expected to decline until oil prices recover.
Against that backdrop, we see a number of imperatives for upstream producers. The year 2016 could be very difficult as price hedges expire and producers become fully exposed to lower oil prices. Several E&P companies filed for bankruptcy in 2015, and the list is expected to grow. Revenue estimates for a group of 134 publicly traded, North American–based E&P companies show a $102-billion funding gap in 2016 (figure 6). That means that without a meaningful increase in prices, producers will have to either improve their productivity—via cost reductions and/or improved capital efficiencies—or sharply reduce their capital expenditures by the equivalent of an additional $102 billion in order to be able to operate within their internally generated cash flows in 2016.
To close the gap, producers must take aggressive action on several fronts, including driving higher capital efficiency, improving field productivity, and reducing G&A.
- Companies should focus on developing and producing only the best acreage based on geologic characteristics and on avoiding marginal plays. Capital efficiency can also be improved by making efficient pad-drilling investments, sharing site infrastructure investment over multiple wells, and focusing on maximizing existing well production.
- Standardizing common tasks and implementing best practices can improve field productivity. Segmenting wells for divestment or shut-in and identifying wells with minimal operating activity and ones to be managed actively for repair and maintenance all help optimize the portfolio.
- Companies must also focus on operations footprints and on rationalizing support structures for new development. They should simplify business processes, ensuring that their resources are commensurate with activity levels, thereby ultimately lowering the cost structure. Renegotiating with suppliers can also result in significant savings.
OFSE’s big adjustments
The oil field services and equipment sector started to boom in 2009. Now the sector must keep adjusting to the sharp decline that began in 2015. From 2010 to 2014, global rig counts grew by 85%, and all geographies saw significant ramp-ups. Both the activity levels and the intensity of the work increased. Onshore well costs grew nearly 20% annually as companies drilled more and more horizontal wells and longer laterals and implemented more-complex hydraulic fracturing programs. Offshore, the continued quest for deeper water resources drove increased competition for specialized equipment, resulting in higher day rates for rigs and support services. That period was a golden age of revenue growth and profitability, and overall industry revenue growth exceeded 10% annually. Similar to many E&P customers, the services and equipment industry expanded capital spending and took on significantly more debt. Overall annual return on capital fell to 10 to 12% in 2014 from the 18 to 20% recorded from 2006 to 2008. Further decline appears likely in 2016.
Profitability among OFSE companies operating within the same sector varies widely (figure 7). The widest profitability gaps exist (1) in offshore drilling and related services, (2) among seismic players, and (3) in the onshore drilling sector. Less-profitable companies in those sectors will have to learn the sources of their disadvantages and implement strategies and programs that will improve their positions over time.
Looking forward into 2016, we expect companies to continue facing significant challenges in the area of profitability as the industry continues reshaping itself in a lower-demand environment. Several strategies will be critical to companies’ survival during a potentially protracted downturn.
- OFSE companies must improve their operating-model basics by bolstering levels of efficiency and execution of service delivery models, pursuing sourcing and procurement savings to get the lowest prices from suppliers, eliminating unprofitable service locations by repositioning equipment and services to higher-demand areas, and continuing to flatten organizational designs as a way of making them more responsive to customer needs while also achieving G&A savings.
- OFSE companies, particularly US-focused ones, must create more-flexible, more-responsive operating models to cope with continued volatility as well as fluctuations in demand. Several strategies could be considered, such as (1) finding specific ways to avoid adding fixed costs, (2) increasing the standardization of equipment and operating models to gain efficiency through repeatability and speed, and (3) developing more-collaborative methods of working with producers that would lead to reciprocal integrated planning and development activities that neither the operator nor the service company could achieve alone.
- OFSE companies should take advantage of M&A opportunities with potential to improve competitive position or to build capabilities that would deliver moreefficient service models for operators to use.
Refining: temporary sunshine in Europe, diesel growth questionable, US coker investments at risk
European balances became destabilized from 2011 to 2014 by the revival of the US refinery business and by new capacity in the Middle East and Asia. In 2015, the US economic recovery, US maintenance plans, and the declining share of diesel generated higher-than-expected growth in gasoline products. European refineries faced stronger demand for excess gasoline too, driving margins to unexpectedly high levels. However, we anticipate a hard landing on margins in 2016, because current installed capacity could absorb the next 20 years of demand growth at 10 million barrels a day. Furthermore, an additional 12 million barrels a day (figure 8) in new capacity will arrive on the market through 2035, driven by aggressive investment plans in the Middle East and Asia.
That new capacity in Asia and the Middle East could face challenges because local demand is weaker than expected and diesel growth remains questionable. Recent changes in market sentiment on diesel, as well as improved gasoline product technology, may curb diesel growth, and therefore, current forecasts may be overly optimistic.
To reconfigure old, uncompetitive refineries, biofuel conversion is attracting new investment in Europe, potentially changing the outlook for established biofuel players. Low distillate output remains a challenge for Europe mainly because of heavier crude mix and lower demand for fuel oil and bitumen. Refiners are still questioning the value of large coker investments in Europe.
Continued adjustment to the postboom environment will challenge every sector of the oil and gas industry. Each faces its own, unique set of opportunities and obstacles. Recent oil price volatility, in particular, underscores the extent to which the adjustment process remains unfinished. And the process may yet include further shifts that affect everything from global supplies to the availability of credit and financing options. Recalibrating to flattening demand in developed markets, greatly reduced need for equipment and services, and margin pressure for refined products will require specific strategies and approaches for each sector.
Not every company will survive the transition. Before the modest, anticipated price rebound occurs, emerging-market demand will be one of the relative bright spots, along with US producers that adjust their break-even points. The arrival of a broader market recovery may come later than expected in light of recent oil price lows and ongoing market fluctuations. Also, the near- and medium-term effects, if any, of the Paris climate accord remain to be seen. Regardless of timing, this postboom environment will make 2016 a year of cutting capex, streamlining operations, increasing M&A activity, restructuring, and focusing on geographies where break-even points are low enough to sustain profitability. All of those measures will be required in different sectors of the industry, and they will help, but this will be a notably challenging time.
12016 AlixPartners’ Oil & Gas Outlook. The Outlook is an annual update on the state of the industry and the latest thinking on trends that may shape the coming year. All references, facts, and opinions contained in this article can be found in the 2016 Outlook.
This article regarding Global Oil and Gas Industry Outlook: 2016 A Year of Transition (“Article”) was prepared by AlixPartners, LLP (“AlixPartners”) for general information and distribution on a strictly confidential and non-reliance basis. No one in possession of this Article may rely on any portion of this Article. This Article may be based, in whole or in part, on projections or forecasts of future events. A forecast, by its nature, is speculative and includes estimates and assumptions which may prove to be wrong. Actual results may, and frequently do, differ from those projected or forecast. The information in this Article reflects conditions and our views as of this date, all of which are subject to change. We undertake no obligation to update or provide any revisions to the Article.
The information contained in this article is also subject to the terms, limitations and assumptions contained in the 2016 AlixPartners’ Oil & Gas Outlook, a copy of which can be provided upon request, including those assumptions, disclaimers, and other limitations contained in that study.