An Excerpt from 'Musings from the Oil Patch'
March 10, 2015
By Allen Brooks
Managing Director, PPHB
Global crude oil prices peaked in mid-June and began drifting lower slowly but didn't drop below $100 a barrel until early/mid-August. From there, the pace of the decline began to pick up as the $80's were reached in early/mid-October and the $70's in early/mid- November. On that fateful Thanksgiving Day (a turkey of a day for oil industry participants) when Saudi Arabia officially nixed the idea of cutting its production in order to support oil prices for the rest of its fellow OPEC members and other significant oil exporters, West Texas Intermediate (WTI), America's benchmark crude oil price, sat at $73.70. Internationally, the price quoted for European Brent crude oil was $77.39 a barrel. In approximately 45 days, the Brent spot oil price shed slightly over $32, reaching a low on January 13,2015, of $45.13 a barrel. In the case of WTI, it took nearly 60 days for the price to lose slightly more than $28 a barrel, hitting its low of $44.08 a barrel on January 28, 2015. From the peak to the recent trough, Brent has fallen by 61%, while WTI dropped 59%. Since then, the oil market has rebounded somewhat in response to slightly improved economic data for the United States, the Eurozone and Japan. China's economic results have been much more muted leaving analysts guessing how much oil it may need to import. The net result of the oil price rebound is that from the peak in mid-June to the end of February, the declines are 54% for WTI and 46% for Brent.
The recent oil price lows were set in an environment of extreme uncertainty. Would they mark absolute lows for this cycle or merely delineate temporary lows before falling further in the spring as the absence of demand coupled with unrelenting increases in supply are rapidly filling available storage facilities. Once storage tanks are full, oil prices will need to drop again in order to entice buyers, primarily refinery operators but also speculators, to step up purchases.
Instead of watching falling oil prices, oil and gas exploration and production and oilfield service company managements were aggressively cutting their capital spending plans and announcing employee layoffs. These actions were taken in an attempt to right- size the business for its anticipated level of activity. Managements were optimistic the downturn would have a "V" shape, similar to what was experienced during the 2008-2009 downturn and subsequent recovery. As time has gone on, however, that view is being dismissed as the forces behind this downturn appear to be more long-lasting and thus require additional time to correct. The duration of time required remains an elusive guesstimate.
Initially, a number of managements accepted that the downturn would be more severe than the one experienced in 2008-2009 and began preparing for an extended period of low oil prices, even though they had no idea of exactly how low prices would go or how long they would remain low. As a result, when managements began cutting spending and employees, most did so with meat-cleavers rather than scalpels. Two surveys conducted by prominent Wall Street investment banks suggested that exploration and production capital spending this year would decline significantly. The surveys were conducted by Cowen and Company and Barclays and were prepared late last fall just as the oil price collapse was becoming evident. Much like a slow-motion train wreck, companies prepared their capital budgets using assumptions of what the oil price would average in 2015 knowing that their estimates were slowly sinking. Recognizing that their oil price assumptions were just that, assumptions, they prepared budgets utilizing different, and in most cases, significantly lower oil prices. As a result, when the investment banks' surveys were announced, many observers thought they were unrealistic. However, they began focusing on the alternative spending reductions based on lower oil prices; the reality of how difficult 2015 would be for the industry became clearer.
Cowen's study forecast that global E&P capital spending would decline 17% in 2015 to $571 billion. But that projection was based on oil prices averaging $70 a barrel. Cowen reported that at a $60- a-barrel average price, spending would drop by 30-35%, or roughly twice its initial estimate. Surprisingly, the Barclays survey wound up
at about the same spending cut assuming a $50 a barrel average oil price for 2015 although the survey's initial projection called for a reduction of about half the Cowen forecast at $70-a-barrel oil pricing.
With industry spending cuts of 30-35%, activity was destined to collapse, and it has. The drilling rig count, as reported weekly by Baker Hughes (BHI-NYSE), has dropped by 664 rigs from its recent peak established the week ending September 26, 2014, to the week ending February 27, 2015, shrinking the active rig count by over
one-third. Surprisingly, during the crisis of 2008-2009, the active rig count fell by 1,155 rigs from peak to trough, a period that extended for 39 weeks. If we assume the current rig correction will match the earlier one, the industry still needs to lay down another 500 active rigs. We would like to make two points about this comparison. First, the 2008 peak had exactly 100 more active rigs than last fall's peak. Second, the current downturn from its peak has lasted 22 weeks. At the same point in the 2008 correction, only 28 more rigs had been shut down than now. So has this rig downturn been worse than 2008? It would seem to be the case until one recognizes that the prior downturn started with many more rigs and still had more active rigs at the same point where we are now in this downturn. Key questions are whether this downturn needs to last as long as the prior one did, and if the rig count needs to fall to the same level as in 2009. If it needs to last as long as 2008-2009, then the drilling industry needs to endure another four months of falling rigs. If we have to cut another 500 rigs, at threcent weekly pace of 40+ rigs per week, we are looking at only another three months. As shown in Exhibit 1, the shape and pace of the rig downturns have been very similar. If this downturn continues to follow the earlier one, then we likely have 7-8 weeks of weekly rig count declines as experienced in the past two weeks before the rate of decline slows and we reach 39 weeks of downturn duration. The good news from this analysis is that we may be nearing a bottom in the rig decline. The bad news is we don't know when or how fast the rig count might rebound.
Exhibit 1. Current Rig Downturn vs. 2008-2009 (Source: Baker Hughes, PPHB)
While the rig count is one indicator of current oil and gas industry activity, it doesn't tell much about underlying changes that may be going on in the business. Those changes only become apparent when we look back at measures of activity or results. We sense the events we are observing and the comments we are hearing mean that structural changes in the global oil and gas industry are underway. We have been ruminating about some of these observations and their potential significance. One such observation is the analysis of the history of the oil industry and its interpretation for the future suggested by iconic Boston-based money manager Jeremy Grantham of GMO.
In his firm's 2014 third quarter investor newsletter, Mr. Grantham commented on the role of energy, and especially that of coal and oil, in our economic history and our future. The article was titled, The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose). Mr. Grantham is an avowed supporter of climate change research and steps to mitigate the impact. He and his wife have established a foundation to support this research. In the letter Mr. Grantham points to the need for cheaper energy sources to displace oil, which he says will be renewables. He wrote, "The only longer-term price relief and net benefit to the economy will come when either we reverse recent history and start to find more oil more cheaply, which will be like waiting for pigs to fly, or when cheaper sources of energy displace oil."
Mr. Grantham's analysis of the past and his outlook for the future is based on a study of the relationship between U.S. average hourly manufacturing earnings and the price of a barrel of oil from the end of the Great Depression until now. (We tried replicating his chart as shown in Exhibit 2 in an attempt to bring it current, but we failed. We came close, but our work created several unusual data points – primarily higher values in the early 1940's and in 1998-1999, suggesting that the price data we used may have been different from that used by Mr. Grantham. Having dealt with Mr. Grantham in the past, we will accept his chart as accurate.)
Exhibit 2. Phases of Oil Affordability and Wealth Creation (Sourcde: GMO)
As Mr. Grantham pointed out, in 1940 one hour's work for an American engaged in manufacturing could buy 20% of a barrel of oil. Twenty percent of an oil barrel equals roughly eight gallons. Since one gallon of oil contains the energy equivalent of 200 to 300 man-hours of labor, eight gallons would mean 1,600 to 2,400 man-hours of labor, a significant achievement. As shown within the circle labeled the Golden Era of Income Gains, the affordability of oil increased at a steady rate beginning in 1940 such that by the end of1972, one hour's work controlled 1.1 barrels of oil, over a five-fold increase in about 33 years. Mr. Grantham calls this "the greatest surge of real wealth in U.S. history."
Note that beginning in 1972, when America's oil self-sufficiency ended, OPEC's power grew, leading to the First Oil Shock (1973's Arab Oil Embargo) and eventually the Second Oil Shock (1979's Iranian Revolution), after which oil affordability fell to a new low. Between 1979 and 1999, peak oil affordability was re-established, but this time the improvement was less smooth and it was achieved during a period of falling oil prices. Another recent study pointed out that after 1981, the price of oil declined for the next 17 years, bottoming out at $13 a barrel in November 1998. Adjusted for inflation, this was the lowest price for oil since the 1940's when its affordability began to climb. What troubles Mr. Grantham is the trend in oil affordability observed since the end of the last century. Since then, affordability has now fallen to where it was in 1940.
Another key development has been what has happened to the trend in worker productivity throughout the modern era, and how it relates to the evolution of oil affordability. As oil affordability was improving between 1939 and 1972, oil intensity per person was increasing, but productivity per man-hour increased at the rapid rate of 3.1% a year. Since 1972, oil affordability has fallen and oil usage per person has declined, but productivity per man-hour has also declined such that the average increase for this entire period was only 1.1% a year. Mr. Grantham suggests that the difference in these long-term productivity rates is extremely significant. As he points out, at a 3.1% rate of increase, $1 will grow to $21 in 100 years. But at 1.1%, in the same length of time, $1 will barely grow to $3. Also very disturbing is that since 2000, the average annual productivity increase has been 0.8% a year!
While Mr. Grantham can't definitively link these two trends, he notes that the data is compatible with the thesis that falling oil affordability has dominated our energy equation and poses a serious threat to the nation's income and wealth generation capability. One may want to take that relationship a step further and ask whether it may help to explain why U.S. (and possibly even global) economic growth has remained so weak since the bursting of the Internet bubble in 2000, despite the best efforts of our monetary and fiscal authorities to pump up growth. So does this relationship have implications for how the oil and gas industry may change?
If we are destined for oil affordability to stay at such a low level and thus condemn our economy to perpetual slow growth, it is hard to see how oil prices can rebound anytime soon. On the other hand, we know that the cost of finding new oil supplies is rising, a favorite point of Mr. Grantham's. Just how much can oilfield technology limit that increase, or could it hopefully reverse it? Many people believe the shale revolution has significantly altered the oil industry, but the more important question may be whether this change has set our energy business on a new, permanent course of unlimited supply growth, or whether we merely are enjoying some additional time to effect a transition to the next energy source to power the world. This is Mr. Grantham's position. He wrote in his newsletter article, "What I'm trying to describe here is on one hand a remorseless and historically unprecedented rise in the costs of delivering oil to the marketplace, which is sapping economic strength globally, and on the other hand (and simultaneously) what will be the beginning of an accelerating transference of demand away from oil under the impact of surprising technological progress in alternative energy."
If you are a Saudi Arabian oil official, you have to be concerned by Mr. Grantham's projection for the future for the oil industry. He admits that with the addition of fracking to the equation, "the outlook for oil and energy is the most complicated puzzle I have ever come across." His outlook has to be terrifying for Saudi oil officials. "My guess is that oil prices will bounce around for most or all of the next 10 to 15 years as first one side of this tug of war moves ahead and then the other, with perhaps another 2008-type spike (or two) in the price of oil, after which prices will plateau and decline as electric vehicles take over, and one by one, oil's remaining uses are slowly replaced." If you are a newly-minted exploration and production or an oilfield service company CEO you have to be worried that Mr. Grantham's predictions are correct. But maybe your career will be over by then. But what about your pension and stock option wealth?
Another issue confronting oil and gas companies is whether they have been entrenched in the mal-investment phase of the industry's business cycle. This is the phase when "irrational exuberance," to borrow a term coined by former Federal Reserve Chairman Alan Greenspan, takes over and capital is literally thrown at "sure" projects that ultimately turn out to be disasters. Some interesting work on the topic of mal-investment and its potential implications for future economic activity and risks has been conducted by Louis- Vincent Gave of Gavekal Dragonomics Global Research. In a piece Mr. Gave penned late last year, he leaned on work done by Josh Ayers of Paradarch Advisors showing what has happened to capital spending by the oil and gas sub-components of the Standard & Poor's 500 Stock Index beginning in 2006. Notice from the chart in Exhibit 3 that the share of total capital spending was firmly within the 3% to 4% range during 1992-2006. Following 2006, that share began climbing as oil and gas prices took off. After reaching 8% during the 2008-2009 financial crisis and resulting recession, spending climbed further reaching 10% in 2014 as a decade of extraordinarily high oil prices convinced oil company managements that there was no end in sight to profitable investment opportunities.
But as the chart in Exhibit 4 shows, starting in 2006, returns began declining despite the capital spending faucet being wide open. We are well aware of the debate over the financial management of a number of E&P companies who continually overspent their cash flows, but were able to tap the debt and equity markets to raise capital along with receiving injections of funds from private equity investors and even from some of the largest oil and gas companies in the world who had initially missed the shale plays. Many of these companies are in distress, so maybe we are seeing the verdict on that debate.
Exhibit 3. Oil Industry Capital Spending Hit Record in 2014(Source: Gavekal) Exhibit 4. Oil Industry Guilty of Poor Capital Stewardship (Source: Gavekal)
A key question Mr. Gave asks is whether we have reached "peak demand" for oil? He is not sure, but if we have, he wonders whether we are destined to have to live through years in which markets and investors need to digest the past handful of years of misallocation of capital by the oil industry. So when we read the comments by Doug Suttles, CEO of Encana Corp. (ECA-NYSE) at the time of his year- end earnings report, during which he announced a reduction in the company's capital spending plans for 2015 to between $2 billion and $2.2 billion from its December 2014 projection of $2.7 billion to $2.9 billion, that he was reluctant to cut his budget further but would rather focus on other "financial options" to protect the company's balance sheet and oil and gas production ambitions, we were surprised. Mr. Suttles said his reluctance to cut spending further was because his strategy depends on developing four North American unconventional resources plays and he doesn't want to jeopardize the plan. He plans now to raise $1 billion of new equity.
Mr. Grantham and Mr. Gave have given us a lot to consider as we think about how the next few years will play out for the oil and gas business. We wonder whether any of these thoughts are being discussed in the boardrooms of energy companies. We suspect they are not being considered as the recent successful efforts of the major oil companies to raise billions in new debt, Canada's Cenovus (CVO-NYSE) to sell C$1.6 billion in new equity, and private equity funds to complete record fund-raising efforts dedicated to energy investments have many executives focused more on what it will take to get through the next few months rather than thinking about steps to enhance or protect shareholder value for the long-term. Slashing and burning is a tactic for survival but not a strategy for dealing with the failure to properly manage capital. Resolving that failure, while gutting one's organization, will make it extremely difficult to deal with an industry future dictated by slower underlying growth.
Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating and planning for the future. The newsletter is published every two weeks, but periodically events and travel may alter that schedule. As always, I welcome your comments and observations. Allen Brooks