The oil and gas industry: Navigating the new normal

The exploration and production sector has been acclimatising itself to the ‘new normal’, with crude oil prices trading around $45 to $55 per barrel during 2017. And crucially, many companies have ‘reinvented’ themselves to be profitable at this level.

by Kevin Schroeder, managing partner of Grant Thornton’s energy industry practice in the US and leader of the global energy and natural resources industry.

While I expect the situation to remain largely stable over the next six to, maybe, twelve months, the price environment beyond contains many uncertainties.

That’s not merely because of the inevitable uncertainties involved in making any prediction. It’s also due to many forces in play – from geopolitical uncertainties to technological and efficiency advances in the oil and gas sectors. Other factors include the fine balance of global supply and demand, inventory levels, future sentiment of OPEC (and other large non-OPEC members) and the US private sector’s ability to grow US production unchecked. The significant sums of private equity money ready to be invested, future drilling and completion costs, and other matters such as weather and depletion of shale reserves are all additional relevant issues.

These matters have the potential to disturb the current balance and result in continued volatility and uncertainty into 2018.

Companies should therefore use this time to ask the questions around how they can thrive during fluctuating price levels, and at the same time make smart investments for the future while securing the right resources. 

Finely balanced supply and demand

Ultimately, the primary factor that influences the price of oil is the relationship between global supply and demand. Right now, this is very finely balanced, particularly given the November 2016 decision by OPEC countries to reduce production for a period to support prices. This policy is now due to extend until March 2018, following the recent (May 2017) OPEC meeting in Vienna.

But OPEC is only part of the picture. Large non-OPEC countries have the ability to upset supply and demand. Today, the US and Russia each produce a roughly equivalent output of around 10 million barrels a day – each around the same as Saudi Arabia. While OPEC and 11 non-OPEC members, led by Russia, are collaborating to maintain the previous production cuts, they face real challenges. Russia has an upcoming election. Saudi Aramco is poised for the largest initial public offering in history. At the same time, a higher oil price will drive further US shale production and see OPEC and other large oil-producing countries risk the loss of global market share. It’s a fine balance. 

The forces of disruption

In fact, there are some clear indications that this balance is about to be further disrupted. The disruptive forces are active on my doorstep – in the US.

Right now, it’s easy for US oil companies and investors to feel pretty good about the industry. Significant technical advances in the drilling and completion processes, lower costs, use of real time data, analytics and cloud computing are offering great advantages and have driven down the time and cost of shale oil and gas extraction.

Companies that were in bankruptcy have returned stronger than ever after emerging from Chapter 11, with their assets intact and freed of their debt burdens. The stronger companies that were able to avoid bankruptcy are mostly even stronger today and have extended their footprint in core basins and have put more rigs back to work. The industry is also taking advantage of excellent US oil fields – with multiple pay zones and efficient infrastructure in place – such as the Permian Basin, SCOOP and the STACK.

US crude oil and gasoline inventories have recently declined more than expected and the price of oil has been barely unchanged. With billions of dollars of PE funding poised to pour into the industry, production increases and a significant inventory of drilled and uncompleted wells, market prices continue to be tempered. And it almost goes without saying that the administration now in Washington favours home-grown production – with reduced regulation.

As a result of these forces, there’s a sense that US oil companies have both the ability and the market opportunity to produce more – but at what price? Particularly, the Permian players are motivated to produce at record-breaking levels, which could be up to 8 million barrels a day in upcoming years.

At the same time, the talk of offshore opportunities is heating up. New development in the Gulf of Mexico has been out of favour lately due to the pricing environment and because of the focus onshore in the US. However, I would not be surprised soon to see Gulf development picking up.

Asking the big questions

The big question is this: If the US does unilaterally increase production, could OPEC and countries like Russia be expected to sit on their hands? And if OPEC started to chase market share, what would be the impact on the oil price? Could companies that can generate a profit at $45-a-barrel do so at $35 or $25?

On the other side of the argument, ask an engineer about depletion. The reality is that initial shale oil production falls rather quickly. Are companies prepared to expose themselves to the costs of exploration just at the time when it feels as though the industry’s finally on an even keel? Oil field services costs will also rise with production. Will costs (and the availability of rig and other services equipment and crews) curb production increases? How will down-spacing practices impact ultimate reservoir recoveries and individual well economics? Acreage costs should also not be ignored, which many fail to factor into exploration and production (E&P) KPIs.

Then there’s the question of talent. Many bright people have left the industry in recent years, driven out by the desire to find a more stable and secure career path. If there is a strong bounce back, will companies be able to entice them to return? Without them, will they have the resources and expertise fully to exploit recovery?

These are just a few examples of factors and uncertainties impacting the industry and ultimately the price of oil.

More effort required

Significant strides have been made in improving efficiency across the industry. In the light of uncertainties, however, I strongly believe that yet more effort is required.

I am in favour of companies shoring up their balance sheets – and I believe they should take advantage of the short-term stability. They should prepare for the continuing long-term uncertainty and volatility, which is inevitable. Successful companies are focusing on their core assets and living within cash flows to have capital and liquidity available for uncertain times. Those poised for success are also continuing to pay down debt and maintaining favourable debt to EBITDA ratios.

I also believe oil and gas companies need to embrace the digital era as enthusiastically as industries like aero-engineering, where failure rates are predicted with minute precision. The days should be behind us when a guy needs to drive out to a well to give it the once-over, finds he hasn’t got the right tools and has to return the following week. Instead, the industry should be using digital tools like data analytics, robotics and AI to enable self-diagnosis, drive new efficiencies, and eradicate wasted effort. For example, production output at the deep reservoirs of the Permian basin has increased to levels not seen since the 1970s, due to efficiencies and new technologies allowing long horizontal drilling.

So now is the time to plan for the future and thrive in the new normal.