16 Dec Part 3 of the Prolonged Pandemic Series
1. Less wells = less production = less cash flow
The ability to immediately reduce drilling provides operators short-term relief in terms of cost-savings; less money is going out the door. However, due to the short-cycle nature of unconventional oil and gas development, a dramatic drop in drilling will in short order lead to a correspondingly dramatic drop in cash flow. This then exacerbates a separate headwind to additional drilling – the market’s demand for returns.
A seemingly short 24 months ago, markets rewarded energy companies for growing their production base. When focused production growth led to oversupply as opposed to increased (or any meaningful) profits, the market did an about face and began to punish E&Ps for any behavior that did not contribute to returning cash to investors.
Why does a decrease in drilling, or more accurately completions, lead to a drop in cash flow? It is important to understand that in unconventional oil and gas development, drilling and completion activity is a leading indicator of production volumes. Shale wells have a different production profile than traditional vertical or conventional wells. Whereas conventional oil and gas wells exhibit declining but relatively stable production volumes over long periods of time, unconventional shale wells typically exhibit 6-18 months of flush production, after which time production volumes rapidly decline by up to 80% as they enter what is termed terminal decline. This pattern has been termed falling off the cliff and entering the long tail. It is also why shale has been analogized to a large treadmill – new wells must constantly be drilled to maintain production volumes.
Thus, 6-18 months after drilling and completions stop, production volumes follow a similar linear decline. When production follows drilling off the proverbial cliff, cash flow is not far behind. Should the pandemic depress demand and thus price through 2021, the corresponding decline in production will lead to a commensurate decline in cash flow available to operators.
2. Decrease in cash flow destroys returns to investors, which leads to the acceleration of capital flight and eventually consolidation.
Capital flight from the oil and gas industry, which began in earnest in 2019 has accelerated in 2020. The markets – both public and private – have made it crystal clear that the oil and gas industry must end its decades-long pattern of capital destruction in the name of growth and focus in earnest on returning profits to shareholders. Low performance and increased competition for capital vis-à-vis tech markets have created intense capital flight away from the industry. As oil and gas companies find themselves increasingly cut-off from traditional sources of funding, the status quo has dramatically changed. The industry as a whole has shifted from growth-focus to survival, and here survival depends on the financial means to weather the downturn.
With access to the cheap and plentiful credit that fueled the previous ‘booms’ now cut off, companies are now forced to largely live within cash flow or operate out of accumulated cash. Companies unable to generate free cash flow from present operations due to their high-cost structure or their relative stage in field development find themselves in a bind – they are unable to finance new operations or adequately execute on maintenance. Unable to continue on the shale treadmill, their ability to return cash to investors enters terminal decline. This leaves these operators with little choice outside of insolvency or acquisition.
H2 2020 has seen well, or at least relatively well, capitalized majors – e.g. Exxon, Chevron, Devon, Pioneer – begin the acquisition cycle in earnest. Should the pandemic continue on through 2021, resulting in a continued low-price environment which leads to correspondingly low returns, the number of vulnerable companies faced with insolvency or acquisition will increase exponentially. Consolidation will occur en masse.
3. What is the most likely outcome? Consolidation and Concentration
Should the pandemic continue on relatively unabated through 2021, the most likely outcome for the domestic oil and gas industry is Consolidation and Concentration. Simply put, there will be fewer companies in all areas of the industry – E&P, services, mid-stream – focused on a smaller, tighter geographic footprint.