By Mark Harrington
Over his 35-year career, Mark Harrington has served as Founder, Chairman or President of seven private and public E&P, oil services and Energy Private Equity Groups. His article originally appeared in the website of OilPro, an online community of oil and gas professionals sharing industry information and opportunities.
We’re in a major seismic event for our industry. The operative questions: “Is this the foreshock and the big one has yet to come?” Or, “Has the big one hit and we are now experiencing the aftershocks?”Anyone capable of answering these questions, please raise their hand.
So yes, we live on the San Andreas Fault. We know quakes will come; but fail to recognize the warning signs when they come. And lessons of the prior quakes are often quickly forgotten.
Price volatility comes with the turf; along with massive ebbs and flows of capital. As the up-cycles take hold, many become more convinced each day that, “This time it will be different.”
- The 1-2 punch of 1982-86—exacerbated by a decade of bloated corporate G&A.
- The 1998 punch- exacerbated by CAPEX budgets that were driven by the illusion of “Just-In-Time Reserves” from 3D.
- The 2008 punch- exacerbated by short-term supply/demand imbalances that had sored natural gas prices and natural gas focused rig counts.
- Now the 2014-2015 punch- exacerbated by the notion that finally the day of manufacturing reserves and production was upon us through new unconventional reservoir extraction technologies.
- G&A became more disciplined;
- 3-D became a science rather than a promoter’s tool;
- Natural gas came back into line and is growing in demand; and now
- Unconventional technologies are expanding almost geometrically, while pricing of those services becomes more favorable.
All that said, the recurrent “this cycle will be different” psychology still ignores the overreaching fundamentals of supply, demand and available inventory.
Reality check— Within OPEC agendas remain as bifurcated today as they have been for the past 30+ years.
The Price Doves, those with the highest oil revenue per capita, want longer-term market share. That roster and agenda, has not changed.
The Price Hawks, those with very low oil revenue per capita require higher prices to support their political regimes. They may be the largest group of members, but at the end of the day, the Price Doves will set the price, through the power of swing production.
This down leg is quickly turned more ferocious then in the past. Why? Never before seen inventory levels. In an environment of normalized inventories, an additional 1MM BOPD of surplus supply would not be nearly as it is today. Economics 101—the price of the commodity is set at the margin and prices will decline until demand exceeds supply.
Not to be forgotten on the supply front: new offshore projects coming on line, production bumps from refracs, and emerging exploration theaters in Africa, Mexico and elsewhere.
Undisciplined CAPEX programs and ample capital to feed the frenzy has, and continues to, create the most painful lesson the industry has had in a down cycle.
What’s still to come?
- A second wave of Hard Credit Defaults– Commercial lender’s price decks will continue to be revised downwards. When oil hit $45 the first time, there were still lenders using a V recovery price deck with crude prices of $65- $80 per barrel 1-2 years out.
Borrowing Base calculations on that price deck saved many from a hard default on their facility. Lenders were also content as they avoided more scheduled loans and thus cuts in their lending capacity. Here comes Wave Two and it will be a nasty one.
- Capital Markets shut tight– During the brief dead cat bounce in prices, a few companies were able to refi their debt through double-digit high yield offerings. The investment bankers said yes to highly questionable credits, as their clients sought higher yields in their portfolios. The risk spectrum of the underlying credit became secondary.
Coupled with the V recovery thesis, not surprising that some of the estimated $120 billion in bottom fishing capital found a quick home. Impatient “ready, fire, aim” investors will see defaults on interest coverage ratios of their newly issued securities. Here comes a group of busted deals to further seal off capital markets.
How does an enterprise with decent survivability odds migrate through this?
Answer—time to get “Back to Basics” with a portfolio of time tested strategies.
- High-graded areas of focus that fit a stressed price deck of $30-40 flat. Capital providers and stakeholders should favor managements that grow stakeholder value in a flat price environment. Price upside is a market dividend that compensates for the risks of being in a cyclical commodity.
- Refocused business objectives away from crowd-oriented metrics. Preservation and measured growth in fundamental asset values versus myopic focus on IRRs that require a correct price guess with a meaningful lead time.
- Attract the best talent, and pay up for what you get. People produce the numbers that make the company; it’s not the numbers that make the company and drive the people needed to be hired.
- Joint ventures driven by oilmen’s terms, not promoter’s terms. Plenty of opportunity coming, and a joint effort of two companies with solid and complimentary expertise can make that work well.
- Extremely tight field supervision and cost control. Many decisions were based on a revenue growth model. In today’s environment, it’s field level cost containment. A growth in production and cash flow in a flatish price environment is still the hallmark of astute management.
- Deep-dive search for new proven technologies. A “Buddy-Buddy” system may have worked when services and products were in short supply; but those days are gone for some time to come. The plethora of new products and services springing out of R&D efforts awaits from of a multitude of service companies; no one or two service providers ever have all the answers. Trading for significant discounts off rack pricing is secondary to finding what works best in targeted reservoirs.
- CAPEX programs quickly resized to fit flat price risk adjusted cash flows that maintain a conservative capital structure.
These may not seem to be the most exciting strategies put forth; but they have allowed many companies to survive and thrive through all legs of the cycle. Best to end up as the exploiter rather than the exploited.