Will The Oil Industry Face An October Surprise Of Its Own?

The last two months have been eerily parallel to last summer – oil price starts sliding on concern about strong supply growth in July, then in August focus shifts to worries about the health of oil demand. It is in this market environment that October could shape up as one of the most pivotal months in the oil and gas industry  – not just for 2016, but potentially through 2020.

Oil and gas producers finalize their capital budgets this time of year. These business plans typically have a rolling five-year horizon to provide context of where the company wants to be by 2020. Companies slashed 2015 capital spending by $145 billion and deferred over $200 billion of future projects, making this the second year in a row of a weak price environment. Those that can will keep budgets as flexible as possible to build in optionality.

The timing of the price decline since June could be as big an influence on company confidence as the absolute price level. In June, they might have been thinking of an oil market in the $60s rising to $70/bbl or more. A budget predicated on $70/bbl might seem like a distant pipe dream. How aggressively a company cuts could tell us how optimistic it is about near-term oil price prospects, as well as where it is in the project investment cycle.

Oil project development is not a light switch. Producers cannot instantaneously increase production in reaction to the price environment, not even with shut-in production. Most oil projects take years to develop and the chart below shows much of those $200 billion of deferred projects are “mega projects”– such as oil sands, deepwater and LNG – that can typically take five years or more from financial commitment to first oil.

But to get to 2020, these companies have to survive 2016 and that’s where a number of uncertainties exist. There are always risks, mostly around geology or regulatory structure, and some of my oil patch friends see themselves as “natural owners” of these risks. There are new risks and stakeholders in the capital spending process. For the past few years, companies had easy access to capital (at a low cost relative to historic levels), in part due to both Quantitative Easing and a booming price which attracted debt and equity investors –fueling unprecedented and, at times, uneconomic growth.

Bankers actually want a say in the budget; it is the bank’s money at risk, after all. October is the time thesebanks redetermine RBL (Reserve Based Lending) borrowing bases, which establish available debt. Historically, banks have used a curve about 20% below the first year strip. I was surprised to hear from some bankers this discount might actually shrink to about half that. I don’t expect sizable companies to go belly-up when they receive their new terms. But a number of the smaller producers, public and private, may well reach the end of the road. This will have little effect on supply, and is more about market sentiment than direct impact on activity. Few of the main producers have much RBL exposure, and those that do haven’t used much of their RBL-based revolvers. Prevailing price (and, therefore, cash flow) and the corporate strategies of the big operators will have a far greater impact on supply.

Larger-volume operators have other concerns.  Few companies are cash-flow positive at today’s price. For the Majors and the largest independents, dividends have so far been sacrosanct, bolstering investor confidence. Only a few have chosen to pull this lever. But as market valuations fall, yields could become unsustainably high. Most have the financial capacity to absorb the cash burn for some time, but will all chose to? My corporate colleagues estimate the price required for the largest 60 companies to maintain current spend levels and shareholder distributions is $70/bbl Brent, down from over $90/bbl last year. They believe further capex cuts in 2016 are inevitable if low prices persist, and dividends may only be spared for the very strongest operators.