COVID-19 financial risk management: Implications for the oil and gas industry
COVID-19 financial risk management: Implications for the oil and gas industry
Since the start of 2020, the price of oil has suffered the largest drop in the past 30 years, driven by two reinforcing factors: demand decrease emerging from COVID-19 pandemic, coupled with the failed negotiations between OPEC and Russia. After never completely having recovered from the drop in 2014, when it fell from $108 to $50 per barrel within six months, in March 2020, the price nose-dived from around $60 to $27 per barrel.
In a global health crisis that caught most of the developed world unprepared, the global economy is heading for a recession, with all industries being hit by these unprecedented events. However, some industries are feeling the initial economic implications of the pandemic more than others. Travel, airline, and oil and gas producers are currently among the hardest hit, when the global quarantine grounded approximately 3 billion people globally in March, killing travel virtually overnight. The oil and gas industry is additionally hampered with the ongoing conflict between Saudi Arabia and Russia sparked over production cuts and culminating just before the explosive pandemic growth. On top of the price war between Saudi Arabia and Russia, resulting in over-production that suppressed the oil markets, there came demand destruction caused by the COVID-19 pandemic, sinking oil price further.
When and how things will return to normal is contingent on fast-evolving factors, from geopolitics to the global fight against COVID-19 that includes developing vaccines, containing the virus, and stopping re-infections. As with any crisis, some companies will struggle to survive, while others will position themselves for fast recovery by being vigilant about their cash flow or by seizing opportunities as they arise, particularly those that involve acquiring undervalued companies that would add value to their existing portfolios.
How bad is the impact of COVID-19 on the oil and gas industry?
Although the COVID-19 pandemic is still in its early days, the economic impact of global lockdowns is already of an order that is unprecedented in modern history. By examining GDP growth projections in Figure 1, one can assess the degree of the negative impact that the pandemic is anticipated to have on GDP growth rates of selected countries. Although illustrative, it’s important to note that any forecasts at this stage are hindered by a high degree of uncertainty.
Similarly, Figure 2 illustrates how oil prices fared over the previous year and the effect of the OECD dispute culmination in tandem with the pandemic explosion.
As BCG analysis points out, oil and gas companies’ decline has been happening for some time following an 80 percent in value since 2014.
Not all players have suffered equally within each segment, however. Some have outperformed their peers by applying multiple levers — for example, making changes in their portfolios and by making dramatic improvements inefficiency.
How did the industry respond?
In response to COVID-19, the oil and gas industry has made immediate movements to curtail financial loss. The rig count has fallen, companies announced cuts on discretionary spending, capital budgets have been reduced and earnings forecasts revised downwards. Oil and gas stocks across the whole value chain have dropped, putting some companies at risk of not being able to refinance the debt or meet existing debt covenants.
In the near term, a key question for all oil and gas companies will be if they have the financial cushion to tide them over during the storm and potentially even capitalize on the turmoil in the industry.
What’s next: Possible COVID-19 scenarios
In a recent report, McKinsey lists five factors that will primarily drive the behavior of the pandemic in the next year and determine either its spread or control: the growth of new transmission and evidence of seasonality; the impact of physical-distancing measures; efficacy of health-system surge as countries are working hard to provide their hospitals with ventilators and other critical medical supplies; preparedness to navigate recurrence; and the emergence of herd immunity for which more than two-thirds of the population would need to be immune.
The report proposes several scenarios of the COVID-19 economic impact, stating that most of the leaders expect one of the less severe scenarios to unravel. These scenarios are based on the assumption that the spread will eventually be controlled, and catastrophic structural economic damage is avoided leading to V- or U-shaped recoveries. However, the so-called “black swans of black swans” scenarios, although extreme, cannot be entirely excluded. They involve the possibility of structural damage to the economy on the back of a yearlong pandemic crisis until a vaccine is widely available, combined with ineffective policy response to prevent mass-scale bankruptcies, unemployment, and a financial crisis.
The report then continues to estimate the degree of negative impact in terms of duration on different industries, with the top three industries being commercial aerospace, air & travel and insurance carriers (McKinsey, 2020). Commercial aerospace and air and travel companies are expected to lose 44 percent of their stock price, but the recovery path will differ between the two sectors as the former is not expected to bounce back before Q3 and Q4 of 2021, while the recovery of the latter is expected in Q1 or Q2 of 2021. The next hardest-hit industry is insurance, where companies are expected to lose a third of their stock price, but the recovery is expected by the end of 2020. Insurers are followed by oil and gas companies, which are expected to lose 48 percent of their stock price but are facing a significantly shorter recovery time, with an expected bounce back in Q3 2020.
Charting the response with shock geometry
According to Harvard Business Review, when assessing the impact of a shock, the important scenario question is the shape of the shock — “shock geometry” — and its structural impact. In other words, we need to consider what drives the economic impact trajectory of a shock and then assess where the current pandemic fits in.
There are lessons to be drawn from the past. The global financial crisis has led to recessions worldwide, but with highly different trajectories and recoveries. Three countries, Canada, the US and Greece, presented in Figure 4, illustrate this point.
What is it that drives “shock geometry”? According to HBR, the key determinant is the shock’s capacity to damage an economy’s supply side, and more specifically, capital formation. With disrupted credit intermediation and the capital stock that doesn’t grow, recovery is slow and the shock becomes structural.
The risk profile of the COVID-19 crisis is particularly damaging. While there is a policy rulebook for dealing with financial crises, there is no off-the-shelf solution for liquidity problems of entire real economies.
What it means for the oil and gas industry
Global oil and gas markets are facing an unprecedented challenge: demand is collapsing because of the COVID-19 pandemic, while supply, already overabundant, is considerably increasing. The International Energy Agency (IEA) estimates that global oil demand is set for its first annual drop since 2009 due to the deep contraction in oil consumption in China, and major disruptions to global travel and trade. Ever since China became the world’s largest oil and gas importer in 2016, what happens in this country has major implications for global energy and oil markets. The increase in Chinese consumption is mainly driven by the growing demand from new plants, which have added 900,000 barrels per day of oil processing capacity.
Cities under quarantine and the freeze of economic activity inevitably have a negative impact on energy demand, oil included. Once there is evidence that the outbreak is contained and the economic disruption is in remission, sentiment on oil should improve, bringing prices back up.
Actionable steps for oil and gas companies
- Watch how and where the pandemic is evolving and conduct scenario analysis based both on epidemiological and economic factors.
- Communicate a clear plan to mitigate risks and ensure business continuity. Implement your business continuity plans. Update contingency operational plans as the emergency unravel. Determine critical factors to maintain operations and supply chain. Make sure your IT infrastructure and your cybersecurity are both up to the challenge.
- Communicate with and stay loyal to your customers. Help them with solutions that will make a difference and strengthen relationships that will last beyond the emergency.
- Support and protect employees. Increase communication, balancing the business needs with confidence building, so employees know that their well-being is part of the company’s priorities.
- Revise working policy, allowing remote work where possible and making it practical and simple.
- Establish a response center and urgently assess the financial impact. Stress-test regularly the top line, P&L, and cash flow, and in particular, your main markets to estimate key sensitivities.
- Establish a three-month forecasting process and centralize liquidity management. Focus on cash management to enhance liquidity. This means cutting back capex, large opex, and share buybacks. Your financial strategy should be to preserve cash above all. Implement stricter cash control. Connect with your critical suppliers to weather through supply chain disruption.
- Negotiate and restructure commitments — convert large accounts payable into debt securities; redefining covenant defaults; restructure debt schedule.
- Review budgets to establish a new baseline. Identify marginal investments and discretionary items that can be cut down.
- Assess asset profitability at the field or well level and how much cash will the assets generate given the current prices? Take a balanced approach as the short term cost reduction should be assessed in the context of preserving long-term objectives.
- Identify and leverage all available pockets of growth. Be creative and agile.
- Think beyond the current emergency and consider the post-COVID-19 environment to ensure not only a timely and adequate response in the short term, but adaptation to change, and stronger reemergence in the mid- and long term.
- Keep an eye on the market and move preemptively. Even in a market downturn, there are ways to capture market share, whether as the result of customers’ behavioral changes or because conditions allow you to buy distressed assets.
- Rethink strategy for the next phase, with every business assumption open to question. We may be heading to a new normal and companies need to develop a strategy to navigate the new equilibrium.
- Imagine the post-pandemic world and think about what will change for good. What new opportunities will emerge; how will supply chains operate and with what new safeguards; how will the change in travel patterns affect the business?
- Prepare for the bounce back. Be ready for bold moves; consider making changes to strategic decisions, the portfolio, and the operating model.
Lessons learned from previous downturns and what they mean for investors
In a recent report addressing the economic impact of COVID-19 pandemic on oil and gas industry, PWC reminds us about the lessons oil and gas companies learned in the previous downturns, proposing strategic and tactical steps that can help them avoid many of the pitfalls:
- Understand your position. Identify the strengths of your balance sheet and cash flow. Know how to generate free cash and be profitable in a low-price environment and find your break-even point.
- Balance short- and long-term goals when planning the cuts. Don’t lose sight of the post-recovery future. Preserve assets, people and capabilities that the company will need or want then.
- Seize opportunities that you identify with an innovative approach. Enhance relationships with suppliers, customers or partners. Seek M&A opportunities as distressed assets or non-core assets are a potential source of cash for struggling companies. Goldman Sachs has already reported a rise in hostile takeovers amid coronavirus market meltdown. M&As often lead to cost efficiencies, expanded markets, and enhanced relationships.
- Outsource. Move your IT architecture to the cloud, or non-essential functions to external contractors to lower your operating costs and reduce maintenance capital.
- Follow the signs of recovery and be prepared to ramp back up. Being a first-mover allows you to capitalize on the oil price recovery, and secure lower rates from suppliers as you become one of the first to increase spending.
Recovery will come. China, as the world’s largest oil consumer, is showing signs of recovery, hopefully climbing up the V-shape curve. The degree to which oil prices are being driven by demand-side indicators and, in particular, the Chinese economy is over and above destabilizing events stemming from OPEC + conflict. Regardless of the noise and the dramatic moves, none of the countries involved in the clash have an interest in dragging out the conflict for too long as all the major producers face budget deficits at current prices. Although it is still early days, the latest reports from China point to the direction of gradual recovery as the country is making progress towards disease containment and economic activity is getting back to life.
Another strong push for global recovery is the fact that G20 leaders pledged to inject more than $5 trillion into the global economy to reduce the economic impact of the pandemic outbreak. The United States introduced a $2 trillion coronavirus relief package in late March, handing out $60 billion to struggling airlines and offering low-interest loans to fossil fuel companies, and Canada quickly followed suit.
Takeaways for the oil and gas industry
The market is currently very volatile and it’s hard to make predictions due to heightened uncertainty. The oil price plunged, hitting the lowest level in 18 years. But as noted in a recent Financial Times article, it was due to speculation rather than fundamentals. As compared to the IEA’s estimates for the first quarter of 2020, the actual demand for oil is down by less than 3 percent. Oil and gas companies will need to take protective measures to weather the crisis in the short term while setting them up for recovery in the midterm. Economic recovery increases oil consumption, leading to a rise in oil prices.
The oil and gas industry has always been cyclical and volatile and will remain so. Successful companies have been those that weathered the downcycles and managed to emerge stronger. While these downcycles are hard, especially in regard to an unprecedented global crisis like COVID-19, there are companies that are able to implement balanced and informed decision-making to capitalize on the market recovery. For better or worse, COVID-19 has been an equalizing force across all industries and economies. Continuing to navigate the pandemic will require a great deal of international cooperation to ensure that post-novel coronavirus governance implements sound policies and practices to better prepare for the next global threat. As a management consulting firm, our team at CS-STRATEGIES utilizes expertise and experience across different key sectors to lead businesses and government organizations in transition.
Contact our team of knowledgeable consultants to help your organization to minimize risk and safely transverse financial loss during these uncertain times.
- G20 Leaders’ Statement (March 2020). Extraordinary G20 Leaders’ Summit Statement on COVID-19. Retrieved from https://g20.org/en/media/Documents/G20_Extraordinary%20G20%20Leaders%E2%80%99%20Summit_Statement_EN%20(3).pdf
- Jihad Azour (March 23, 2020). IMFBlog: Covid-19 Pandemic and the Middle East and Central Asia: Region Facing Dual Shock. Retrieved from https://blogs.imf.org/2020/03/23/covid-19-pandemic-and-the-middle-east-and-central-asia-region-facing-dual-shock/
- John Corrigan Partner, PwC US (March, 2020). Covid-19 and the Oil Price Collapse. Retrieved from https://www.pwc.com/us/en/industries/energy-utilities-mining/library/oil-price-collapse.html
- McKinsey&Company (30 March, 2020). Risk Practice COVID-19: Briefing Note, March 30, 2020. Retrieved from https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Risk/Our%20Insights/COVID%2019%20Implications%20for%20business/COVID%2019%20March%2030/COVID-19-Briefing%20note-March-30-2020.ashx
- Nick Butler (March, 16 2020). Expect the Oil Price to Rebound — but With a Low Ceiling. Retrieved from https://www.ft.com/content/31547c20-6447-11ea-b3f3-fe4680ea68b5
- OECD (2020), Oecd Economic Outlook, Interim Report March 2020, OECD Publishing, Paris, https://doi.org/10.1787/7969896b-en. Retrieved from https://www.oecd.org/economic-outlook/
- Philip Whittaker, Boston Consulting Group (March 24, 2020). Oilfield Services and Equipment: Double Declines. Retrieved from https://www.linkedin.com/pulse/oilfield-services-equipment-double-declines-philip-whittaker/
- Philipp Carlsson-Szlezak , Martin Reeves and Paul Swartz (March 27, 2020). Understanding the Economic Shock of Coronavirus. Retrieved from https://hbr.org/2020/03/understanding-the-economic-shock-of-coronavirus
- The International Energy Agency (9 March 2020). Global Oil Demand to Decline in 2020 as Coronavirus Weighs Heavily on Markets. Retrieved from https://www.iea.org/news/global-oil-demand-to-decline-in-2020-as-coronavirus-weighs-heavily-on-markets