A March 6th report from Goldman Sachs Equity Research highlights that lower oil prices have led to a “New Oil Order”, and that the management of upstream oil and gas producers needs to come to terms with the basic realities of these new circumstances in order to prosper (or at least hang on) until oil prices rise again.
Goldman Sachs analyst Brian Singer and colleagues argue that the Shale Revolution is not over, it simply needs to slow down growth to meet realistic future market demand. The analysts also offer E&P execs five tips for dealing with life in the New Oil Order, the first of which is “prepare for a U-shaped oil recovery”.
The Shale Revolution will continue…in moderation
The GS analysts emphasizes that U.S. shale growth is an important for the global oil supply, but that future growth should be at “a more normal pace vs. 2012-14.” They also note that U.S. shale plays are “secularly challenged” by lower oil prices. Instead, they argue, it’s the high-cost oil sands, deepwater and LNG projects that might face long-term economic viability problems.
Five key considerations for O&G firms management
The first piece of advice from Singer et al. is to prepare for a medium-term recovery of oil prices, but almost certainly not close to the highs of a year ago. “We believe your sustained cost cuts may exceed your expectations, leading oil supply-demand to balance at $65/bbl WTI.” The GS analysts warn the O&G firms execs to be wary of expensive, long-term investments such as deepwater or LNG projects.
Second, O&G firms execs should “try to raise corporate returns which have lagged.” The Goldman reports note that the rapid growth in shale has come at the expense of cash return, which is down industry-wide compared to the pre-shale era (part of the reason for the poor relative performance of the sector over the last few years). The analysts argue “if you augment volume growth with improved corporate cash returns, generalist investor interest will rise and stock performance will improve.”
Third, prepare for consolidation. The GS analysts point out that higher capital costs in the future is “likely going to shrink the number of optimal producers, warranting consolidation.” They argue that the benefits of consolidation will over time will eventually at least compete with equity or high yield debt issuance. According to the report, “We see consolidation as producers with higher cost of capital sell to producers with lower cost of capital, including majors that are underexposed to shale.”
Fourth, “consider your asset quality, cost of capital and ability to cut costs to determine whether to go-it alone, buy another company or sell your own.” Singer and colleagues say that success in New Oil Order will be related to “asset quality/scale, cost-cutting ability, and cost of capital.” Moreover, firms with strong asset quality, lower cost of capital and the ability to cut costs can pursue go-it-alone or acquisition strategies, but firms with strong assets and higher cost of capital should consider consolidation.
Fifth, O&G firms execs should take advantage of the capital markets. They note that many E&P companies have already sold equity recently. They say this makes good sense as “Ultimately, if cost of capital does not return to 2014 lows, the market is likely to be less tolerant of perennially wide funding gaps.”