MARKET OUTLOOK

That Escalated Quickly

THE RECENTLY (HEAVILY) REVISED 2020+ ENERGY OUTLOOK

By George O’Leary, Managing Director, Oil Service Research Tudor, Pickering, Holt & Co.

It seems that there’s never a dull moment in the oil patch, and 2020 has certainly hammered that reality home.

Just as upstream companies appeared to come to terms with the new paradigm that was created by a seemingly interminable ~$50-60/bbl WTI crude oil price world, COVID-19 fears and the OPEC+ train-wreck coalesced to form the perfect storm, thereby sending WTI crude oil price careening down <$30/bbl.

At these price levels, full-cycle economics simply don’t work for most global reservoirs. So, what will or should oil companies do now? Our crystal ball is admittedly murky today, but that’s nothing new as our prognostications on the future of oilfield activity, pricing and earnings have felt a bit like the famous “Mr. Toad’s Wild Ride” for much of the last six years. However, we do believe sunnier days sit on the horizon as supply/demand dynamics eventually improve. However, before we peel back the onion with respect to how 2020 and 2021 may unfold, let’s a take a little trip down memory lane.

U.S. onshore shale emerged onto the scene as a true potential driver of hydrocarbon production growth in the mid-2000s as oil and gas companies proved that these tight reservoirs could be economically exploited by horizontal drilling coupled with hydraulic fracturing.

Our beloved industry certainly has encountered its fair share of issues through time, but a lack of ingenuity and technological prowess isn’t one of them. Energy companies deployed early learnings from places like the Barnett and Haynesville in oil plays like the Bakken and the Eagle Ford.

During most of the 2008-2014 timeframe, times were good in the oil patch as OPEC supported $80-100/bbl+ crude oil prices. As such, capital flooded into the space and companies were generally rewarded for growth above almost all else. But that wouldn’t last forever.

In late 2014 and in a fashion somewhat similar to the recent turmoil, the world got flip-turned upside down as OPEC decided they’d ceded more than enough crude oil production market share and opened up the production taps. We entered a painful multi-year downturn, but most energy players and investors assumed that we’d eventually see a traditional, powerful oil and gas upcycle as global decline curves kicked in. Given these optimistic views, capital markets were accommodating, and investors generally supported the space, which limited the impact on upstream industry participants.

We’ve been head-faked multiple times since late 2014, thinking that crude oil prices were set to recover and the energy industry might rebound over a multi-year period, only to have those hopes dashed as oil supply growth exceeding expectations tended to drive lackluster crude price and energy equity performance. By late 2018, investors truly and loudly began to bang the capital discipline, free cash flow and return on capital employed drums.

And most energy companies seemed willing to dance to the beat with numerous public companies laying out budgets predicated on a $50-55/bbl WTI price. Investors were holding oil and gas companies’ feet to the fire and it seemed to be paying dividends. Energy companies seemed increasingly focused on protecting and improving balance sheets. Capital markets remained circumspect and certain lenders appeared to be playing hardball, so upstream companies increasingly complied with investors’ desires entering 2020. And then, COVID-19 blunted demand expectations and OPEC+ threw the market a nasty curve ball.

Historically, when oil prices take a notable tumble, rig count decline takes months to fully respond. Look back to 2016 when WTI crude bottomed in February, U.S. land rig count didn’t trough until a few months later. To be fair, that’s changed a bit since 2017 as operators cut activity quickly multiple times with little, if any, warning afforded to their service providers. While we’ll have to wait and see what the near-term future holds, our discussions with industry participants indicate that the activity brakes have already been slammed and completions was first up on the chopping blocks.

During Q2 2020, we expect sharp activity declines to more fully materialize. Among integrated players, large independents, and both small public and private operators, nearly all seem to be rapidly throttling back activity. In some instances, lenders are essentially forcing them to do so. Drilling rigs will also be let go despite the early termination payments that E&Ps will invariably owe the land rig companies. Production-oriented activities often hold up better than drilling and completions-oriented revenue streams in a down-cycle, but it appears that even workover-oriented services are in E&P companies’ crosshairs. So how low do we think U.S. onshore upstream spending will trend in 2020?

Coming into the year, we forecasted E&P drilling and completions (D&C) spend would decline ~13% year over year in 2020. As COVID-19 fears mounted, we began to mull over what D&C spend might look like in a prolonged ~$45/bbl WTI crude oil price world vs. the $50-55/bbl price environment we’d previously contemplated. We believed that D&C spending would decline a startling ~20-30% year over year in 2020.

With crude oil prices cratering, we’ve seen E&P operators announce more draconian spending plans than we previously anticipated. Some companies are now willing to let production decline in 2020 rather than trying to toe the production growth line. This is not true of all E&Ps, as certain companies with the combo of fantastic rock and strong balance sheets can weather the storm better than others. However, deep spending cuts are the rule versus the exception and when coupled with our own macro modeling, they suggest that U.S. onshore D&C capex could decline ~40% year over year ... maybe more.

As such, we now believe U.S. land rig count could fall to 400-450 by 2021 vs. current level of ~770, with active hydraulic fracturing spread count potentially hitting ~130-150 in 2021 vs. current level of ~280-285. This year will be quite painful for U.S. onshore OFS players.

That all seems quite gloomy, so where’s the ray of sunshine promised earlier in this article? While we’re still working through the nuts and bolts of our updated energy macro outlook, it appears that we’re set up for the heretofore resilient U.S. crude oil production to decline on an exit-to-exit basis by Q4 2020, and we expect annual crude oil production declines year-over-year in 2021. Assuming global crude oil demand normalizes in 2021, we could finally see the much-awaited sustained crude oil price recovery materialize.

We believe the fundamental death of oil demand growth has been prematurely and incorrectly called. Outside of OPEC-driven noise, U.S. unconventional production growth has been the primary oil price bugaboo since 2014, but we may finally have reached a point where E&Ps no longer chase growth and upstream players focus more acutely on generating real returns. It’s always darkest before the dawn and things feel pitch-black at the moment, but we firmly believe we’re positioned for notably better days in the energy patch over the long-term.

George O’Leary currently serves as a Managing Director in Oil Service Research. During his 10+ year tenure at Tudor, Pickering, Holt & Co. (TPH), George has covered the midstream, coal, power, engineering and construction, and liquefied natural gas components of the energy space. Prior to joining TPH in 2009, George served as an Associate in the business and intangible asset valuation group with Deloitte Financial Advisory Services, where he primarily focused on valuing assets in the energy space. He holds a bachelor’s degree in business administration with a concentration in finance from the University of Richmond.