The oil and gas (O&G) industry is no stranger to supply and demand shocks, having faced more than a dozen such jolts over the course of the past four decades.
Most of the supply side shocks, excluding 2014’s bump, were the result of sudden supply pullbacks in reaction to geopolitical unrest. On average, the impact these market-tightening shocks made lasted anywhere between one and six months. Demand-side shocks were largely due to macroeconomic contraction and have been closely connected to larger volatile economic cycles—in terms of size and duration.
Despite the shakeups the industry has experienced over the years, however, recent events portend a new and perhaps even more disruptive market:
- A black swan event, COVID-19, is driving a demand-side shock that’s expected to result in approximately 3-5 million bpd through the end of 2020 (Figure 1). Overall, we expect global oil demand to be lower in 2020 than last year, which hasn’t happened in more than a decade.
- Meanwhile, we’re seeing a concurrent supply-side shock stemming from OPEC+ and Saudi Arabia’s plan to open the floodgates on oil supply precisely when the economy is preparing for a contraction.
- About 60 million bpd is used in transportation—road, sea and air.
- A 10-15% contraction in transportation in Q2 is ~6-9 million bpd reduction in crude oil demand.
- A global recession will put further pressure on the remaining 40 million bpd of nontransportation demand.
The confluence of these two shocks creates an unprecedented situation—hence difficult to predict—but if we piece together the various elements of supply and demand in light of these events, it appears that the impact could last well into 2021 (Figure 2) with a disproportionate impact on US production. However, it is safe to say that we are in for a turbulent 2020, and a lukewarm 2021 in which commodity markets will be under pressure, and it’s hard to see any winners at this time given the looming recession. Producer nations, investors, O&G companies themselves, and green/new energy businesses stand to lose.
What's different this time around?
Simultaneous demand contraction and a concurrent ramp-up in supply is unprecedented. We are in uncharted waters, and it isn’t clear who will win this game of brinkmanship. Prices can drop to very low levels till the OPEC+ “flood-the-market” stance continues (Figure 3).
The O&G industry was already in a state of disruption leading up to these events. Sector returns were under pressure, capital was flowing out of the industry, and decarbonization headwinds were strengthening to capital increases. North American operators in particular were in a more precarious position than they were in 2014. Capital availability had almost dried out—investors were cheering capital cuts and penalizing capital expansion. Oil stocks were being hammered across the board and were even below 2014 levels (Figure 4).
Additionally, resources became more abundant, the market more competitive and alternative energy sources more prevalent, pulling the bar lower for alternatives to specific sources of O&G supply. Finally, the downstream sector that served as a cushion in 2014/15 for the industry at large, for pure play refiners, and for international oil companies (IOCs) as a result of improved margins will not be a savior in this cycle – the potential for higher margins will be blunted by reduced volumes as a result of the economic contraction.
What will remain the same?
Despite chatter about peak O&G markets and until recent events threw the market into a tailspin, the demand for both oil and gas was growing. Also, once the global economy stabilizes there's no indication that growth won’t return as the world still needs oil and gas to sustain development and drive prosperity in the developing world, not to mention meeting the needs of an estimated 2+ billion people who’ll join the global population.
Also, while the economics of O&G extraction have improved considerably since the last supply shock in 2014—by up to $10-$20 per barrel—ultimately the full-cycle breakeven economics of the marginal barrel will set the equilibrium price. And that breakeven price is still in the high $50s to low $60s per barrel. Markets can stay irrational temporarily, but ultimately fundamentals will prevail.
Challenging times require an intelligent response
Despite the inherent volatility of the commodity markets, we find O&G companies are often ill-equipped to deal with major demand or supply shocks. With the ongoing disruption coming in the wake of the one-two punch of the demand and supply shock, the first set of actions should be around fortifying the organization for any eventuality—i.e. building resilience. These actions should focus on steadying cash flow, reducing costs, and securing revenues.
We see five critical steps companies can take now to build resilience:
Rethink to emerge stronger
Companies will also need to go beyond traditional measures and take non-traditional pathways to rethink how they operate. Some of the current disruption trends were already in motion before the current supply and demand shock. Today's O&G players will need to fundamentally rethink and reduce their structural costs in non-traditional ways:
1. Create cost variability and eradicate complexity while freeing up capital
Evaluate and identify opportunities to shift cost and business/organizational complexity inherent in delivering or driving non-core technology, support functions and partner platforms. Focus the organization on the core business and maintain flexibility to dial up and down based on resulting market outcomes.
2. Join hands with peers and competitors
Consolidate activity or assets through a formal or loose joint venture particularly in high-volume geographies like North America. This can be in the form of joint development programs particularly for contiguous upstream positions, sharing equipment and workforce, partnering on service agreements and other infrastructure while idling less favorable or sub-scale positions and assets.
3. Bring the ecosystem creatively into play
Identify collaborative opportunities with operational and technology partners and/or service providers that require integrated planning and execution. Take a long view toward releasing trapped value that can benefit all partners while serving as an offset to direct price concessions.
Trying times call for smart measures—both traditional and non-traditional
While the industry has dug itself out of many shocks and proven naysayers wrong in the past (think peak oil that preceded the 2014 supply renaissance and disruption), it is now faced with concurrent disruption at an existential, system-wide and player level—risks that will truly test its tenacity and durability. And while it may force a number of players to fold, those that will emerge will certainly be leaner and stronger.