Executive Viewpoint

Coming back into North America’s land market after working many years in the Eastern Hemisphere has provided me with a perspective that takes me back to the mid-1980s. As the majors settle into different basins, smaller companies and private equity players have seemed to be stranded on a moving treadmill. And then came the March oil price collapse, spawned by the Coronavirus and Saudi and Russian overproduction.

The treadmill. With oil and gas (O&G) prices mired in record-low levels, in constant dollars, smaller players are struggling just to survive. When demand does return to normal, and prices climb higher, these firms will rethink their strategies, and their management teams will struggle to return the necessary cash to private equity. With private equity firms exiting the O&G market in favor of renewables or medical, could a crucial belt on the industry’s treadmill finally be on the verge of breaking?

The question is, what occurs in investment communities during periods of price stagnation, as we had before the Coronavirus? Like every other stock or commodity in trading, investors look at ways to deliver cash returns. They invest in smaller companies, expecting a return on the capital deployed. 

Like the E&P companies, the industry’s service arm needs to return the cost of capital. This becomes the common tie between the service sector and operators. When properties are bought at a premium, with expectations of a higher return, and then the market cycles down, this causes “stranded assets.” The capital has been deployed, but the returns are not there. Private equity firms are stuck waiting on returns, based on the previous assumption, while small E&P companies are forced to wait on returns, based on the capital that was spent. Small E&P companies look to leverage the cost pressures on service companies, to save money on any work that is required, and this cost-cutting becomes a never-ending treadmill. 

While this cycle carries on, service companies drop prices to remain competitive, until they can no longer return the cost of capital needed to sustain themselves. This leads to workforce reductions and shrinkage in the market. Operators must then compete for the services needed to keep this treadmill running. So, when will the belt finally begin to break?

Alignment with the financial sector. What happens, when the industry focuses on “harvesting” an asset, instead of prolonging it? The sector will turn from a production-focused legacy industry to one more aligned to the financial sector. Being an engineer, over the years I have heard industry insiders say things like, “Oh, we just need to get the production out; the money is with our finance group.” 

If you look at how the market has operated in recent months, up to the Coronavirus interruption, private equity groups are consolidating or even learning to be operators. In talking with several of them, they are not in a position to carry that burden. They assumed that they could invest in a management team, drill a few wells, and then flip the property to another large player. Over and over, I hear that we are stuck on this treadmill, or that we are going to reduce CAPEX, or even that private equity groups will wait until the market returns to a higher commodity level before investing. 

The finance industry uses the term, “dead money”—slang for money invested in a security with minor hopes of appreciation or earning a return. It also may refer to money that is locked up with little-to-no yield. Analysts may refer to a stock as “dead money,” warning investors who might purchase the shares.

This has been the state of North American E&P. Consolidation happens with entrepreneurs, who buck the trend and align with service companies to harvest an asset—seeking cash returns as quickly as they can extract hydrocarbons. They worry less about the reservoir and focus more on returns.

Better collaboration. In the North American O&G environment, doing business post-Coronavirus will require better alignment between the financial world and service companies. Both sides have been squeezed, and there has to be a better way to work in a transparently and efficiently. At some point, you cannot continue to put financial pressure on both sides and still get the returns you want. 

The industry needs to move away from its legacy ways, whereby most people focus on the production side. This move must result in an alignment of return on capital for both operators and service companies, and a focus on returns over production. Production is required to fuel the capital expense—or, rather, the sale of hydrocarbons down the pipeline. This results in returns on the capital deployed. There are many commercial models for this, but collaboration between commercial models and all impacted parties must be an important part of any alignment in extracting hydrocarbons. 

Technology will drive efficiency, but efficiency in returns will be driven by refocusing the industry around the speed of extraction. An acquaintance recently commented that we are in a world, where the industry is not being asked to flatten a decline rate, but to determine how every entity involved can get paid more quickly. Moving forward, we must act differently from the past. There needs to be a seamless organization, in which operators and service companies collaborate. 

Once global demand is restored, the industry should adapt and change to this new paradigm. We’re putting a brand-new belt on the treadmill and working to make sure it is aligned better—a necessity in today’s world.