Four Things to Do with US$100+ Oil

Overall, crude oil prices have surged in the past year. The uptick has inspired various oil and gas industry observers to ponder whether crude oil will return to the triple digits – as was the case as recently as 2014.

 

Whether crude crosses the vaunted US$100 mark is anyone’s guess, but the most recent industry downturn has prompted oil and gas companies to adopt a “new normal,” “lower for longer” mentality. This approach includes:

 

  • Emphasising lower-risk, less expensive projects in capital budgets
  • Implementing digitalisation and automation to control operating costs throughout the business cycle

 

To learn how companies can apply this mindset in a boom period, Rigzone caught up with Niloufar Molavi, Houston-based Global and US Energy Leader with PwC. A summary of Rigzone’s conversation with Molavi – presented within a list of four things to do with US$100-plus oil – follows.

 

Keep Activity Manageable

“Don’t give back the gains by ramping activity up beyond the industry’s ability to do it in a well-managed way,” cautioned Ms Molavi, observing oil and gas companies’ behaviour when shale production was first growing in popularity provides a case in point.

 

“The shale revolution resulted in an acquisition frenzy supported by significant investment in the industry with limited prioritisation of returns or free cash flow,” explained Ms Molavi.

 

“In turn, many upstream companies experienced significant balance sheet stress once commodity prices declined in the downturn, which negatively impacted operating cash flows.”

 

The result was that “almost everyone got burned,” Ms Molavi said. She said this included:

 

  • companies over-investing in assets they could not ultimately develop because their balance sheets were stretched too thin
  • suppliers, oilfield services companies and drillers trying to keep up with a fast-growing industry which suddenly slowed down, forcing them to cut prices, stack rigs and sell either parts of or the entire organisation to stronger peers
  • banks and financial investors left with poor returns for years

 

Ms Molavi added that the most recent downturn subsequently forced many producers to prioritise two key financial metrics: return on capital employed (ROCE) and free cash flow (FCF).

 

Should the heady days of US$100-plus crude oil return, those hard-learned lessons will likely continue to influence capital budgets, she predicted.

 

“I think chief financial officers will continue to focus on the short-term ROCE and FCF projects with their capital allocation,” Ms Molavi said. “The will also continue to be conservative in their planning.”

 

Furthermore, Ms Molavi pointed out that many companies use more robust planning compared with, say, five years ago.

 

“Today, companies plan and allocate capital at a field level versus a well level with a view to the full cycle development of the asset in order to drive and achieve the efficiencies they have gained over the last three to four years,” Ms Molavi explained.

 

“This will continue and will drive a more rateable increase in drilling and development activity across the industry.”

 

From an accounting standpoint, an extended emphasis on ROCE and FCF could affect the determination of proved undeveloped reserves (PUDs), added Ms Molavi. She pointed out that companies must comply with US Securities and Exchange Commission (SEC) guidance called the “five-year rule” to determine the volume of PUDs. The rule typically demands that companies be reasonably certain that they will drill PUD wells within five years in order to classify them as proved reserves, she explained.

 

“Revising capital budgets and corporate strategy could necessitate revisions in PUD quantities,” said Ms Molavi. “PUDs have always been a focal point of the SEC in its comment letters and I suspect this will continue in the current environment.”

 

Think Short- and Long-Term

Pointing out that oil and gas companies will likely continue to pursue short-term capital projects with attractive ROCE and FCF, Ms Molavi advised a balanced approach to building portfolios which also target longer-term opportunities to ensure energy for a growing world.

 

“While demand is increasing at lower rates than ten years ago relative to gross domestic product, it is still growing,” she explained. “Given that production has a natural decline, substantial investment is needed to meet that demand.”

 

Because so many producers were stung by the downturn, they will likely exercise considerable caution in expanding their businesses, Ms Molavi continued.

 

“Going forward, I think ROCE and FCE will continue to be a key focus of investors,” Ms Molavi predicted. “However, we will also likely see more conversations about reserve replacement, drillable inventory, position on the cost curve and growth as the industry seeks to meet the demand over the next ten years.”

 

Keep Innovating

“Continue to improve processes and technology during periods of high margins,” said Ms Molavi. “Investing in efficiency often goes away when profitability escalates due to high prices.

 

To its credit, the industry managed to innovate during the bust, she continued. However, she added that the strides were offset by a dramatic loss in human talent.

 

“The industry has gone through a difficult cycle of retrenchment and cost take-out,” noted Ms Molavi. “During this period, the industry improved its down-hole technologies, improved operating processes and technologies, became more robust commercially – both on the supply chain and marketing sides – and lost a tremendous amount of experience and skills due to retirements, lay-offs and reduced recruitment.”

 

Remember Infrastructure

“Invest in infrastructure so that production in shale plays will no longer be limited,” said Ms Molavi, acknowledging that deploying a more balanced capital spending plan with both short- and long-term projects will be a challenge for some firms.

 

Since the mid-decade price collapse, planning capital budgets has been relatively straightforward for oil and gas companies because they have gravitated towards near-term investments which generate cash flow, Ms Molavi explained.

 

“As companies are pressured to show reserve replacement and/or growth, longer-term exploration-type investments will be necessary and CFOs will need to develop approaches to evaluate these investments against short-term, lower-risk opportunities,” Ms Molavi said.

 

“Another challenge is the lack of pipelines and other infrastructure in shale plays like the Permian. Capital input will be necessary in the next two to three years in order to maximise production capacity.”

 

Source: Rigzone