Amidst the Oil Price Rout, Big Oil Faces Headwinds
While the stock market continues to break new records, with the S&P 500’s rise of 7% in August, eclipsing its previous all-time high in February, the market’s enthusiasm is not shared by all sectors.
On August 31st, Exxon Mobil’s removal from the Dow Jones Industrial Average shook up the Oil & Gas industry, leaving Chevron as the industry’s only representative in the benchmark. Once the largest publicly traded US company in 2013, Exxon’s unprecedented removal from the benchmark indicates a historic end to its 92-year journey at the Dow, the longest-tenured component of the index, but is just a glimpse into the sector’s long anticipated transition.
Recent years have proven challenging for the Oil & Gas Industry. The year 2019 was marked by a rise in ESG investing and a supply glut driven by the US shale boom. The excess supply driven by more efficient drilling and production technologies led the US to reach record high natural gas, and crude oil production in 2019. While it may come as good news to some, the heightened production depressed prices, and the technological efficiencies were further shared with the consumption front, tampering oil demand. The increasing pressure for “clean” energy and a recorded average spot price for West Texas Intermediate (WTI) crude oil at about $57 per barrel, 2019 saw lackluster energy stocks performances. With an average return of 11% for the year, the energy sector heavily underperformed compared to the S&P 500’s more than 30% rally. After years of disappointing returns, it was unsurprising that the broader energy sector only represented about 2.5% of the S&P 500 index in 2020 compared to around 11% ten years ago.
As Wall Street became less reluctant to provide funding because of public pressure, the large Oil & Gas players began promoting investments in renewable energy and diversifying their operations. Positioning itself for a lengthy decoupling from carbon, rising population, and economic growth, Big Oil was hit hard by the changing sentiment against itself. The COVID-19 pandemic unprecedently cut energy demand and caused a subsequent price war between Saudi Arabia and Russia as initial talks of an OPEC production cut failed miserably. Global oil demand was obliterated in April, which fell by as much as 30 million barrels per day (b/d), leading to oversupplied storage capacities and ultimately bringing oil futures in negative territory for the first time in history. This exponential decrease in demand forced companies to cut production and slash capital expenditures to survive.
The road to recovery from April’s lows was accompanied by many bankruptcies and financial restructurings. Despite an ease in lockdowns which drove up crude demand, the damage was far too great for many, particularly heavily leveraged US shale producers. The first half of 2020 saw a total of 47 bankruptcies within Oil & Gas producers, oilfield services, as well as midstream service companies in the US and Canada. Small players were not the only victim, Chesapeake Energy, for example, declared bankruptcy on June 28 with more than $9 billion in debt. With WTI crude oil prices closing around $40 in September and no imminent pick-up in demand, what can we expect for the industry?
Despite increased global liquid fuels and petroleum consumption attributable to an ease in travel restrictions coupled with a demand recovery in China, the near-term future remains bleak for the industry. Assuming crude oil prices hover around the $40-50 mark till the world gets a grasp on the pandemic, we should continue to expect additional bankruptcies and forgone investments. Most shale producers’ budget for oil between $55 and $65 per barrel meaning that cost cuts will remain, at these price levels. The largest US players such as Exxon Mobil Corp, Chevron Corp, and Occidental Petroleum Corp, to name a few, turn a profit at $25-30 per barrel on their Permian holdings. With these slim margins, just covering output costs leaves producers lacking cash for dividends and corporate costs, hence the dividend cuts in recent months by players such as The British Petroleum Company plc (BP). On a wider scale, this entails low levels of activity within the sector in the coming months till service costs can come down. On the other hand, the multinational players with strong balance sheets and diversified operations are well-positioned to weather the storm and lead the accelerated energy transition. The demise of smaller shale competitors in the US struggling to turn a profit at these price levels ultimately benefits players operating in the Middle East and North Africa (MENA) region, where output costs are lower.
While the industry’s near-term outlook remains bleak, this does not necessarily entail the end of the Oil & Gas industry. Around 85% of the global primary energy consumption comes from fossil fuels, of which petroleum, natural gas, and other liquids represent 54%, according to the EIA. Additionally, coal, known to be the most harmful energy source for the environment represents 26% of global energy consumption. In order to understand the transition to “clean” energy, one must understand the broader dynamics of the energy sector. In fact, the road to “clean” energy depends heavily on the Oil & Gas industry.
Natural gas will dominate the efficient transition to renewable energy. Leading the way as the cleanest and most efficient fossil fuel, with a 92% efficiency rate from wellhead to home, gas is key for growth and “filling the gap” for renewables. As demand for coal, the world’s slowest-growing energy source, declines, we can expect increased oil and gas consumption in China, India, and Africa; as population and economic growth hold the most promise. Furthermore, an advanced country like Germany where 47.3% of net electricity production comes from renewable sources, still relies largely on imported energy in the form of petroleum and gas. Hence, the importance of reinforcing the sector’s role in energy efficiency and sustainability.
Most big energy companies have debt maturities in 2024, providing some relief for exploration and production companies to weather the storm. The long-term outlook will center itself around natural gas and liquified natural gas (LNG), as the global energy mix transitions to low carbon sources. The bulk of growth within the sector will manifest itself in Asia and Africa, where energy demand will continue to grow as population increases and infrastructure needs are met.
As the pandemic unwinds and demand picks up, we should expect innovation by major oil and gas companies on reducing CO2 emissions with more efficient power plants. M&A activity will revolve around LNG integration and possibly pivoting business models towards alternative energy. As even the most robust global economies contract and uncertainty weeds capital markets, the road to recovery still remains long and arduous. Until then, companies will need to be more reliant on their working capital as debt funding may be hard to come by. While the energy sector is set to experience volatility in the next few months with a US election nearby and uncertainty around the length of the ongoing public-health crisis, it is safe to say that the oil and gas industry will remain at the forefront of the broader energy sector in the next 20 to 30 years.
– With assistance by Can Atakol