Historically, there’s been a correlation between rig counts and oil prices driving capital spending in the upstream sector of the energy industry. Likewise, this has typically been an indicator for the performance of the oilfield services sector as well. However, in 2019, shareholders demanded that E&P companies return capital to shareholders and reduce debt rather than advocate “growth at all costs.” This shift in investor sentiment has led to reduced capital spending and the beginning of the decline in active rig counts despite oil prices during 2019 at or above $50/bbl.
Further indication of the disconnect between rig counts and oil prices has been evidenced post-COVID. In recent weeks, oil prices have rebounded from historic lows, however, rig counts have continued their precipitous fall. Is this a long-term trend or will the correlation return assuming crude prices return to levels at or above $50/bbl? What impact will the above have on the oilfield services sector?
Oilfield Services, E&P Sectors Navigate Volatility
Assuming oil prices trend upward and the supply side of the oil equation moves toward equilibrium, there’s an expectation that capital spending will eventually increase and rig counts will rebound as a result. Until this happens, there are three questions that will need to be addressed in the industry:
- Will shareholders continue to demand return of capital and deleveraging of balance sheets?
- Will borrowing base redeterminations and other credit-related issues decline, increase or remain static?
- Will OPEC+ control their supply to meet demand without negatively impacting oil prices?
In terms of shareholders, it’s very likely that there will be a continued demand to increase shareholder value in the E&P sector. The significant decline in market value of publicly traded companies will lead to continued stress from shareholders and will require upstream oil and gas companies to effectively balance their production, restrain capital spending, lower debt loads, right-size their back-office and create added value for shareholders.
According to the Dallas Federal Reserve Bank in its most recent Energy Survey, the capital expenditure activity index declined significantly during Q2 2020 across both the E&P and oilfield services sectors to their lowest level in the four-year history of the index. Looking ahead, the balancing act will be challenging for management teams in the current environment and in the coming years.
On the credit front, as has been evidenced from the recent borrowing base redeterminations for reserve-based loans (RBLs) earlier this year and expectations for the second round this fall, banks are expected to reduce their exposure to the upstream oil and gas industry in the near-term. The consequences of reduced borrowing bases will limit an oil and gas producer’s availability to capital, thereby reducing capital deployed in the sector at a minimum for the remainder of 2020 and certainly into 2021. In addition, S&P Global Ratings recently indicated that the short-term default risk for oilfield services companies is “very high,” reflecting depressed industry conditions.
OPEC+’s recent agreement to maintain production at reduced levels has been good news from a commodity price perspective. However, the big question remains: how long will the agreement remain intact? This uncertainty will be difficult to predict, along with the persistence of COVID-19. Hopefully, the agreement will remain intact moving supply and demand towards equilibrium.
Oilfield Services Sector Outlook: Cloudy With A Chance Of Survival
What does this mean for the oilfield services sector? The next 12-18 months will continue to be challenging due to the factors mentioned above. The combination of a focus on creating more shareholder value, debt reduction and capital spending discipline in the E&P space is expected to lead to continued restraint in upstream oil and gas spending. In addition, the expectation of lower RBL exposure is another indication of upstream oil and gas sector restraint. Even if OPEC+ output reductions remain in place, there’ll be a time lag to reach supply/demand equilibrium.
Against the current market backdrop, oilfield services companies will need to preserve capital and ride out the storm before they can reasonably expect to see an uptick in activity. Companies in the services sector must continue to be very selective about the capital projects they undertake. Financial accounting considerations, such as goodwill or long-lived asset impairments, will need to be front-of-mind among service company management teams as the current downturn persists.
Additionally, private-equity-backed oilfield services portfolio companies may also be more receptive to the idea of portfolio company/investment combinations, or “smashcos.” In this environment, both sponsors and portfolio companies are looking for cost savings wherever they can find them and, as such, they may be looking for ways to promote cross marketing and other synergies among portfolio companies. Opportune can assist oilfield services companies with these and other considerations in the current challenging and uncertain market.
About the Authors:
Dean Price is an Opportune LLP Partner responsible for the oilfield services sector and the valuation advisory and tax advisory service lines. He has 32 years of experience in valuation advisory and energy consulting serving clients in various segments of the energy industry. Price has extensive experience in performing valuations of businesses and assets for acquisition, divestiture, financing, financial reporting and tax. He has conducted engagements throughout the U.S. and abroad. Dean’s engagement highlights include performing valuations for various segments of the energy industry, such as upstream, midstream, downstream, oilfield services and petrochemicals. He has conducted valuations and consulting engagements in Eastern Europe, South America and Asia for privatization purposes. Price’s 32 years of valuation advisory experience includes eight years with Duff & Phelps as practice leader of the Houston office and 17 years in public accounting with Deloitte and KPMG. Prior to entering public accounting, he spent five years at Marathon Oil Company in the accounting and tax department.
Kevin Cannon is a director in Opportune LLP’s valuation practice based in Houston. He has 15 years of experience performing business and asset valuations and providing corporate finance consulting. His specific experience includes valuations of businesses and intangible assets for purchase price allocations, impairment, tax planning and portfolio valuation purposes.
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