Houston’s oil and gas sector isn’t done adjusting to the strain that came with the start of a global pandemic, but its executives are already casting their gaze downrange to make assumptions about how the pandemic ends.

As recently as mid-May, experts on the industry said a long-term period of social distancing terminating in mid-2021 was hard to even conceptualize. And as some states, including Texas, take steps to reopen businesses and remobilize consumers, the question becomes whether or not a second wave of Covid-19 infections and deaths send the market back into widespread social distancing until a vaccine can be produced.

“I tend to be an optimist, which is why it’s quite frankly hard to think about those realities,” Ken Medlock, a fellow of energy and resource economics at Rice University’s Baker Institute for Public Policy, said on a virtual panel hosted by the Houston Business Journal in mid-May. “If we continue to see wave after wave of this, and people keep social distancing, the future becomes really hard to predict.”

And yet, the people steering Houston’s largest oil and gas companies already have to try and make some predictions about what the market looks like in six months or a year despite the uncertainty still in the market.

“The challenge is, the oil companies need to make a decision today on the case they think will happen, and they’re going to be conservative,” said Paul Goydan, Houston-based managing director and senior partner at Boston Consulting Group. “Even if the best case happens in six months, standing here today as an oil executive, you’re going to make a decision on what you think will happen, and it’s probably not going to be the best case.”

Goydan outlined four broad tiers of responses that companies in the oil and gas business will likely take in response to the ongoing supply-demand imbalance: spending cuts, workforce cuts, portfolio changes and restructuring.

Tier I: Spending cuts

Faced with such severe supply and demand imbalance, capital projects are the first thing to go. This response has already seen wide use, especially among oil and gas producers.

For example, Houston-based Occidental Petroleum Corp. (NYSE: OXY) now plans to spend $2.4 billion to $2.6 billion in 2020, down from its initial estimation of $5.2 billion to $5.4 billion, according to the company’s financial reports. Houston-based Noble Energy Inc. (Nasdaq: NBL) now plans capital expenditures in 2020 between $750 million to $850 million. That’s more than a 50% reduction from Noble’s original 2020 capital expenditure plans. Houston-based Marathon Oil Corp. (NYSE: MRO) cut its original 2020 capital expenditure plans by $1.1 billion, landing at or below $1.3 billion for the year.

“The easiest thing to do, that every oil company goes out and does, is they stop drilling, they stop execution activities in the field,” Goydan said. “There’s a huge wave of activity reductions.”

Oil field equipment and service companies feel the pain from that first — their customers only demand their equipment and services  if they have work that needs doing. Goydan said BCG is generally seeing reductions of 20% to 40% at most companies. And the reductions likely look even more dramatic from the ground level — if the spending plan cuts are taking place partway through the year, that means 2020 spending was likely most intense in its first few months, leaving even less room in those budgets for the back half, Goydan said.

This tier of response results in broad layoffs at oil field service companies, many of which have already taken place.

Tier II: Producer layoffs

Once an extended industry downturn becomes more evident, oil and gas producers will turn their cost-cutting gaze inward and look to reduce their own workforces. By this point, capital spending reductions should have already sliced away jobs in the oil field services, as the producers would want to defend their own workforces.

“It’s much easier to cut a supplier than it is to dig into your own workforce,” Goydan said. “A lot of these companies have thousands and thousands of person-years of engineering and geological expertise. It is very hard to get back if you let go of it.”

Oil companies would rather hold onto that talent and experience so that they are ready to move when the market comes back. It takes a structural change in the way these companies view their prospects to induce them to let those people go, Goydan said.

“We saw in 2014 and 2015 a readjustment to $50-$60 oil,” Goydan said. “Now we’re seeing an adjustment to maybe a $30-for-two-to-three-years world.”

Essentially, if oil companies believe that the pandemic ends and demand recovers quickly, as though the pandemic never happened, oil field service companies probably bear the brunt of the layoffs. But once executives start to think that the demand impact of Covid-19 will outlast the disease itself, they have to start looking at broader changes within their own ranks, Goydan said.

In reality, the broader market is beginning to move on this tier of response now, Goydan said.

“What we’re starting to see is an emerging consensus that it will take an average of two years to get out of this, and probably five years to get back to where we thought we’d be at the end of 2020,” Goydan said.

That shift comes not from an assumption about how long the medical event of the pandemic lasts, but from a belief that the societal impacts of social distancing will change the fundamental demand for fuel as people change they way they work and socialize independent of the pandemic.

Tier III: Portfolio changes

In this stage, companies begin buying and selling assets to adjust their own portfolios to match the new reality. This tier serves the dual purposes of changing the composition of a company’s assets and injecting liquidity into the company’s balance sheet, Goydan said. While some companies that were perhaps predisposed to this solution have already started this sort of mergers and acquisitions activity — like Occidental with its recent megadeal acquiring Anadarko Petroleum Corp. — the market generally hasn’t yet reached the point at which buyers and sellers have an easy time coming together.

“This is not what we would call a transactable market,” Goydan said. “Extreme price volatility in commodities and uncertainty don’t create a good market for portfolio actions and M&A.”

These tiers of responses don’t happen all at once, they progress over time, Goydan said. And there’s still time for companies to start reaching for this sort of activity as a response to the downturn.

The first thing to happen will be distressed sellers coming to the market because they need liquidity to meet financial obligations, Goydan said. These distressed sellers will start to draw out opportunistic buyers.

“At some point, where there are good deals, you start to see buyers,” Goydan said. “And then, at some point, we will converge on a high degree of confidence that we’re in the swoosh (where the downturn bottoms out). When that confidence increases and volatility decreases, that’s where you start to see M&A.”

Tier IV: Restructuring

The final response to the downturn is restructuring. In many cases, this means bankruptcy, as companies that do the prior three tiers of responses find that they simply cannot survive.

“They will take all those actions, and they will find that those actions are not sufficient and they run out of cash,” Goydan said.

There has already been a surge in the number of companies filing for bankruptcy since March, when the market imbalance began to pressure oil prices, but the wave likely won’t hit its peak for several more months, said Jeff Nichols, a Houston-based partner at Haynes and Boone LLP and co-chair of the company’s energy practice group.

The companies that have already filed are still likely those that were already contending with balance sheet issues before March, and were thus probably already negotiating with creditors when the market took a turn for the worst, Nichols said. That means that the companies for which the latest downturn was the start of their problems probably won’t reach the courts until late summer or early fall, Nichols said.

Structurally, these bankruptcies are likely to generally be debt-for-equity deals, wherein a creditor erases debt in exchange for ownership over the debtor, said Sarah Foss, a restructuring analyst for Debtwire.

“The problem is there’s not really another restructuring scenario available other than debt for equity, aside from liquidating,” Foss said. “There’s really not a market out there where you can get a third party to buy your assets.”

But there will also be companies that manage to avoid bankruptcy and come out of the downturn on top, Goydan said. These companies, the “winners,” will end up rethinking their business models, especially around their use of technology.

“They do not want to come out of the downturn looking and acting like they did going in,” Goydan said. “Those are the companies that typically have the most success.”

The imbalance

Covid-19 pandemic has already put incredible strain on global fuel demand, but the balance is further complicated by economic conflict between Russia and OPEC member states.

The major players in the international oil and gas business have all taken oil production offline — production they will want to bring back as prices recover, Goydan said.

The base-case scenario has those producers acting with some level of coordination to ease production back into the market as prices go up, which still slows any recovery in oil prices. But there’s also a worst-case scenario, Goydan said.

“It’s more of a long-tail worst case, where geopolitical or other tensions lead to a complete breakdown in coordination and a fight for market share,” Goydan said. “There’s not really a best case. There’s a likely case that puts a ceiling on it, and then there’s a whole bunch of cases where things break down and it gets much less rational.”

Uncertainty about the future in the supply side combined with the already-weak demand to push crude oil futures into record-shattering negative-price territory for a couple of days in April, but even since then futures contracts have stayed close to the $30-$40 per barrel range, according to data from the U.S. Energy Information Administration.

“I don’t think any company has really stress-tested their strategy at these oil prices ($30 per barrel at the time of his interview),” Goydan said. “No one ever would have ever envisioned this destruction of demand. It’s unprecedented.”

The future

In a best-case scenario, in which the Covid-19 pandemic never hits a second wave and social distancing can cease sooner rather than later, these tiered responses probably stop partway through tier two for most companies.

“I would think that if you’re in a ‘best case,’ you see very little phase three or phase four activity,” Goydan said.

Conversely, as more time passes without an end to social distancing, more companies have to move onto the more extreme phases, Goydan said. As it stands now, the industry is already on a path to see job losses on the producer level — that’s tier two — but if there’s a “miracle recovery,” there will be many fewer bankruptcies and distressed portfolio adjustments, Goydan said.

Outside the oil patch

Further downstream from the oil and gas producers, refiners and LNG companies are also feeling some pain. Refinery utilization rates are down 20 to 25 percent across regions, and the pressure on refiners will continue as long as the pandemic is still suppressing demand, said Clint Follette, another Houston-based BCG managing director and partner. If social distancing continues deep into 2021, some of the smaller refineries might end up having to shutter their operations permanently, Follette said.

But refineries generally aren’t as cash hungry as the companies producing crude oil upstream. They still have certain sustaining costs, but most of the larger facilities, like those near Houston, are pretty resilient, Follette said.

“It’s not like the upstream, where it’s sucking up capital,” Follette said.

Petrochemical companies are also having a tough time, though demand for their products hasn’t sunk quite as low as that for fuels, Follette said.

“It was already a tough environment for the chemical industry, because a lot of capacity had already come online. You had a little bit of oversupply even before this disruption,” Follette said. “They went from a bad margin year to a worse margin year.”

Houston’s burgeoning liquefied natural gas industry is also contending with issues. Natural gas production as a byproduct of crude production, called associated gas, has gone down as oil companies cut spending. That has reduced U.S. feedstock supply for LNG exporters and pushed domestic natural gas prices up, making exports to international destinations — where the pandemic is hurting demand — less attractive, said BCG analyst Alex Dewar.

“It’s a bizarre situation where U.S. gas is pricing above Europe and Asia,” Dewar said.

LNG facilities along the Gulf Coast have been built or modified at great expense over the past several years to export the incredible quantity of natural gas being produced via onshore drilling.

That means that, even in a world where the pandemic ends in the short term, that probably pushes up domestic supply more quickly than international demand, further hurting LNG exporters in the short- and medium-term, Dewar said.

As an industry in its early stages, many U.S. LNG export hopefuls are still working on projects to increase their capacity. But none of those projects are likely to move forward as long as current conditions persist, Dewar said.

“It’s challenging to see how anyone reaches a final investment decision in the next several years,” Dewar said.

In fact, The Netherlands-based Royal Dutch Shell walked away from an export project in Lake Charles earlier this year, and Houston-based Liquefied Natural Gas Ltd. sold out of its flagship development project essentially at a total loss.

By Joshua Mann – Senior Reporter

Courtesy of the Houston Business Journal

https://www.bizjournals.com/houston/news/2020/06/19/oil-and-gas-cos-navigate-a-downturn.html

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