Will Higher Oil Spell Trouble For Upstream Discipline?

(WoodMac, 19.Apr.2021) — In its rebound from the 2020 downturn, Brent flirted with US$70 per barrel. Higher prices in 2021 mean higher cash flow for producers, perhaps even record-setting highs. Have the good times returned?

Global natural resources consultancy Wood Mackenzie believes operators need to be cautious.

“While prices over US$60/bbl will always be better for operators than US$40/bbl, it’s not all one-way travel,” Greig Aitken, a director with WoodMac’s corporate analysis team, said.

“There are the perennial issues of cost inflation and fiscal disruption.

“Also, changing circumstances will make strategy execution more challenging, particularly as it relates to doing deals. And there’s the hubris that comes in every upswing, when stakeholders begin to regard hard-learned lessons as outdated views. This often leads to over-capitalisation and under-performance.”

Aitken said operators should remain pragmatic. The blueprints for success at US$40/bbl are still the blueprints for success when prices are higher.

But there are a number of issues operators should keep in mind.

Firstly, supply chain cost inflation is inevitable.  The supply chain has been hollowed out. It’s barely sized to service the austere world of sub-US$50/bbl activity levels. A rush of activity would very quickly tighten markets causing costs to rise swiftly, such is the lack of headroom in the market.

Secondly, fiscal terms are likely to tighten. Rising oil prices are a key trigger for fiscal disruption. Several fiscal systems are progressive and set up to raise government share at higher prices automatically, but many are not.

Aitken said: “Demands for a ‘fair share’ become louder at higher prices, and strengthening prices won’t have gone unnoticed.

“While oil companies resist changes to fiscal terms with threats of lower investment and fewer jobs,  this could be weakened by plans to wind down or harvest assets in certain regions. Higher tax rates, new windfall profits taxes, even carbon taxes could be waiting in the wings.”

Rising prices could stall portfolio restructuring too. While many assets are up for sale, even in a US$60/bbl world, buyers would still be scarce. Aitken said the solutions to a lack of liquidity are unchanged. Would-be sellers have can either accept the market price, sell better-quality assets, include contingencies in the deal, or hold on.

“The higher oil climbs, the more emphasis shifts to holding on to assets,” he said.

“Taking the prevailing market price was an easier decision when prices and confidence were low. It becomes more difficult to sell assets at a lower valuation in a rising price environment. The assets are generating cash and operators have less pressure to sell due to their increasing cash flow and greater flexibility.”

However strategically high-grading portfolios is essential.

Aitken said: “It will get harder to hold the line at higher prices. Companies have talked a lot about discipline, focusing on debt reduction and increasing shareholder distributions.

“These are easier arguments to make when oil is US$50/bbl. This resolve will be tested by rebounding share prices, increasing cash generation and improving sentiment towards the oil and gas sector.”

He said, should prices hold above US$60/bbl, many IOCs may head back towards their financial comfort zones more quickly than if prices are US$50/bbl. This provides greater scope for opportunistic moves into new energies or decarbonisation. But this could also be applied to reinvesting in the upstream cash cow.

The independents may see growth quickly return to their agendas: most US Independents have self-imposed reinvestment rate constraints of 70-80% of operating cash flow. Deleveraging is the primary target for many highly-indebted US companies.

“But that still leaves space for measured growth within rising cashflow,” Aitken said. “Moreover, few international Independents have made the same type of transformational commitments as the Majors. They have no such reason to divert cash flow out of oil and gas.”

He added: “Could the sector get carried away yet again? At the very least, the focus on resilience would give way to a discussion about price leverage. If the market were to start rewarding growth again, it is possible.

“It could take several quarters’ worth of strong earnings results to materialise, but the oil sector has a history of being its own worst enemy.

“To us, the answer is clear. Oil at US$65/bbl is better for producers than oil at US$50/bbl. But what was a good idea just a few months ago – capital restraint, financial fortitude, focus on resilience –  remains a good idea today.”