Four Things to Do with $100+ Oil
Overall, crude oil prices have surged in the past year. The uptick has inspired various oil and gas industry observers to ponder whether crude oil will return to the triple digits – as was the case as recently as 2014. Rigzone has even joined this speculative exercise, as this recent article illustrates.
Whether crude crosses the vaunted $100 mark is anyone’s guess, but the most recent industry downturn has prompted oil and gas companies to adopt a “new normal,” “lower for longer” mentality. This approach includes:
- Emphasizing lower-risk, less expensive projects in capital budgets
- Implementing digitalization and automation to control operating costs throughout the business cycle
To learn how companies can apply this mindset in a boom period, Rigzone caught up with Niloufar Molavi, Houston-based Global and U.S. Energy Leader with PwC. A summary of Rigzone’s conversation with Molavi – presented within a list of four things to do with $100-plus oil – follows.
Keep Activity Manageable
“Don’t give back the gains by ramping activity up beyond the industry’s ability to do it in a well-managed way,” cautioned Molavi, observing oil and gas companies’ behavior when shale production was first growing in popularity provides a case in point.
“The shale revolution resulted in an acquisition frenzy supported by significant investment in the industry with limited prioritization of returns or free cash flow,” explained Molavi. “In turn, many upstream companies experienced significant balance sheet stress once commodity prices declined in the downturn, which negatively impacted operating cash flows.”
The result was that “almost everyone got burned,” said Molavi. She said this included:
- companies over-investing in assets they could not ultimately develop because their balance sheets were stretched too thin
- suppliers, oilfield services companies and drillers trying to keep up with a fast-growing industry that suddenly slowed down, forcing them to cut prices, stack rigs and sell either parts of or the entire organization to stronger peers
- banks and financial investors left with poor returns for years
Molavi added that the most recent downturn subsequently forced many producers to prioritize two key financial metrics: return on capital employed (ROCE) and free cash flow (FCF). Should the heady days of $100-plus crude oil return, those hard-learned lessons will likely continue to influence capital budgets, she predicted.
“I think chief financial officers will continue to focus on the short-term ROCE and FCF projects with their capital allocation,” Molavi said. “The will also continue to be conservative in their planning.”
Furthermore, Molavi pointed out that many companies use more robust planning compared to, say, five years ago.
“Today, companies plan and allocate capital at a field level versus a well level with a view to the full cycle development of the asset in order to drive and achieve the efficiencies they have gained over the last three to four years,” Molavi explained. “This will continue and will drive a more ratable increase in drilling and development activity across the industry.”
From an accounting standpoint, an extended emphasis on ROCE and FCF could affect the determination of proved undeveloped reserves (PUDs), added Molavi. She pointed out that companies must comply with U.S. Securities and Exchange Commission (SEC) guidance called the “five-year rule” to determine the volume of PUDs. The rule typically demands that companies be reasonably certain that they will drill PUD wells within five years in order to classify them as proved reserves, she explained.
“Revising capital budgets and corporate strategy could necessitate revisions in PUD quantities,” said Molavi. “PUDs have always been a focal point of the SEC in its comment letters and I suspect this will continue in the current environment.”
Think Short- and Long-Term
Pointing out that oil and gas companies will likely continue to pursue short-term capital projects with attractive ROCE and FCF, Molavi advised a balanced approach to building portfolios that also target longer-term opportunities to ensure energy for a growing world. “While demand is increasing at lower rates than 10 years ago relative to gross domestic product, it is still growing,” she explained. “Given that production has a natural decline, substantial investment is needed to meet that demand.”
Because so many producers were stung by the downturn, they will likely exercise considerable caution in expanding their businesses, continued Molavi.
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