‘Lower for longer’ oil prices, industry finances and growth

Tight oil producers have embarked upon a new growth phase. Endowed with low-cost resource, they can leapfrog a period of balance sheet rebuilding by tapping eager equity markets and zero straight in on the money. Conventional players have more limited economic growth options and need to be innovative to rebuild their capital base.

The ship has been ‘righted’, as they say. Oil and gas companies have done a good job over the last two years cutting costs, investment and dividends. The industry as a whole is free cash flow neutral at today’s Brent price of around US$54/bbl, way down on the US$91/bbl needed in 2014.

But not everything in the garden is rosy in 2017 - the sector’s finances have deteriorated significantly.

Our Corporate Analysis team, led by Tom Ellacott, shows that for the sixty companies we cover in depth, net debt has increased by 22% or US$142bn since 2014; financial leverage has doubled to an average of 36%; and US$250bn of fresh capital is needed to return balance sheets to the pre-oil price crash levels.

Despite the financial stretch, some companies’ focus is already shifting to growth. Investment is surging once again into tight oil. Resilient through the downturn, the Permian Basin is leading tight oil plays back up and in a big way. Exploitable resources have continued to expand and can be drilled far more efficiently.

There are understandable concerns already surfacing about cost re-inflation, with the horizontal rig count up by 313 or 101% from the lows of last year. Parts of the supply chain such as proppants and pressure pumping are particularly sensitive. Our view is that overall costs could rise by 10-15% by end 2017. Even so, a vast undrilled inventory of wells has break evens at US$55/bbl or lower.

Tight oil is now the primary growth engine for global oil supply over the next decade.

We forecast volumes can more than double from the Q3 2016 low of 4.1 million b/d to 8.6 million b/d by 2026. This will require significant investment and many tight oil operators face negative cash flow as they commit to increased spend.

But the sector’s weak balance sheet may be no impediment. US independent operators have raised US$31bn of equity in the last thirteen months to strengthen finances and fund growth, with almost US$2bn raised in January alone. Investors’ current appetite to pump equity into the strong growth plays seems almost insatiable, in spite of the risks posed to margins by rising costs.

What’s unusual about this ‘up cycle’ is that investors are buying into an investment theme that isn’t a bet on rising oil prices – arguably it’s the opposite.

Many operators’ plans are premised on ‘lower for longer’ oil prices, and some assume prices actually decline from current levels as production grows. This is logical. Rising volumes of low break even tight oil will effectively keep a lid on prices and push out the need for higher cost developments and higher prices.

It’s a different world outside the US L48 where signs of a new growth phase are harder to find. Progress has been made in cutting costs and Shell’s Kaikias in the Gulf of Mexico, sanctioned this week, is evidence that individual projects can get over the line. The best deep water discoveries (e.g. Brazil, Guyana and Senegal) can compete commercially with tight oil. But much more work needs to be done on the vast bulk of projects for operators to have the confidence to commit scarce capital.

Unlike tight oil independents, conventional players don’t have access to new equity to fund growth.

Our calculations suggest the sector will generate no free cash flow through 2020 if prices stay around current levels, or ‘lower for longer’. There will be little or no organic de-leveraging.

A period of innovative financial restructuring lies ahead to rebuild balance sheets and reset for growth - more cost cutting, strict financial discipline and raising capital through portfolio high grading and asset sales. The process should result in better capital efficiency across the industry with assets shifting from the highly leveraged to those with access to capital and able to invest.

The latter camp includes the Majors, as well as Asian NOCs looking to bolster flagging production profiles.