From Boom to Bust — Oil's Wild Ride
Date September 2015
Featured in the Journal of Corporate Renewal
In the past 12 months, the energy sector has resembled a roller coaster ride as the price of oil has once again experienced wild cyclical swings. Starting north of $100 a barrel for West Texas Intermediate (WTI) in August 2014, oil prices spiraled downward to below $50 a barrel by February 2015 before settling in around $60 per barrel during May and June. That brief period of price stability lasted until the Greek referendum vote injected uncertainty into the European economic markets and sent WTI into the low $50s again in early July. Subsequently, oil has dropped into the low $40s per barrel as the news out of China has continued to impact global oil prices.
Amid all of this market turmoil, several energy-related deals unfolded, including the bankruptcy of Green Field Energy Services, which led to the disposition of hydraulic fracturing equipment, the largest such disposition in U.S. history. The Green Field disposition was a 12-month orderly liquidation of assets valued at $250 million that reflected the impact on oilfield equipment values as prices for a barrel of oil fell by more than 50 percent over the period.
Until about a year ago, a bull market in oil had led to unparalleled growth and expansion in the energy sector. The large exploration and production companies (E&Ps) were in a strong growth mode, with seemingly unlimited resources and an insatiable appetite for developing new projects. The capital markets were strong, and E&Ps trading on the public markets benefitted greatly from the macroeconomic energy environment.
Oilfield service providers were also reaping the rewards of strong market demand at the time, which in turn led to higher day rates and greater profitability for producers. Despite dramatic swings in oil prices worldwide, oilfield operators in North America were actively looking to grow revenues. There was no clearer picture of that insatiable appetite for growth than the experience of Green Field. When the liquidation of equipment formerly owned by the company began, buyers wired millions of dollars before invoices had even been initiated. The demand for drilling new wells and servicing existing wells was clearly at historic levels, and there was no shortage of ready equipment buyers at high recoveries.
Much of the growth in North American energy production was attributable to the shale boom facilitated by new technological developments in directional drilling and hydraulic fracturing, or “fracking.” These techniques essentially changed the global landscape for oil and gas production. With its historically heavy dependence on imported oil, the U.S. had previously been at the mercy of the Organization of the Petroleum Exporting Countries (OPEC), but these new technologies led to dramatically increased oil and gas production in North America.
Before the development of directional drilling and fracking, the supply and pricing of oil were essentially dictated by OPEC. Prior to late 2014, whenever market conditions drove down oil prices, OPEC would simply reduce output to bring supply in sync with worldwide demand. In essence, OPEC was the worldwide market maker.
That changed in 2014. While different theories of the reasoning behind the change in its tactics, OPEC publicly declared that it would not reduce output despite the growing world supply of oil and much lower prices. Even as industrial demand slowed, largely due to reduced growth in China and a slow European economy, OPEC chose to continue to produce at previous levels. At the same time, the North American oil and gas industry was producing at record levels. The confluence of these events had a predictable outcome—falling prices for oil.
Impact on Investment, Asset Values
In North America, the impact of the changes in the global oil markets was relatively slow to develop. As oil prices slipped below $100 a barrel, opinions on the future price of oil were extremely widespread. While some predicted that the price of oil would fall below $70 a barrel, others maintained that despite its pronouncements, OPEC would eventually decrease production. As the realization set in that OPEC was not bluffing and that the reduced consumption by China and Europe that many had feared had become a reality, the market price for a barrel of WTI began to fall.
In the equipment disposition market, the reduction in demand for oilfield assets was slow to take shape. A number of new wells that had already been started when oil was over $100 per barrel needed to be completed, but additional new drilling activity began to drop off after that. A more limited decline in oilfield services followed as maintenance demands for existing wells remained despite the curtailment of new drilling activity. But as oil prices reached $70 a barrel, another noticeable change began to take place.
Depending on the oil field and the technology used to drill, the breakeven price per barrel could vary dramatically across different regions. However, in almost all cases, purchases of oilfield equipment became more need-based as opposed to opportunistic. What also became abundantly clear was that equipment buyers were having a much harder time securing funds to close deals when oil fell below $70 per barrel, and recovery values began to drop off. Unlike the large E&Ps that had strong balance sheets and access to the public markets, many midsized companies had to rely in large part on private equity to fund new capital spending. The number of operators making quick on-the-spot decisions to buy equipment soon diminished significantly.
As oil prices continued to drop it became clear that the midsized companies were more leveraged and more susceptible to market forces. This trend became even more pronounced as oil fell into the sub-$50 per barrel price range and many of these highly leveraged midsized companies fell into distress. For example, one hydraulic fracking company that had purchased several million dollars’ worth of assets during the Green Field disposition while oil prices were at their peak eventually was forced to liquidate after prices fell below $50 per barrel.
While some companies have ultimately shed assets or filed for either bankruptcy in the U.S. or Companies’ Creditors Arrangement Act (CCAA) protection in Canada, lenders have been slow to foreclose on the assets. Creditors seem to realize that with oil prices at very low levels, taking over the assets to try to recover loan balances through traditional liquidations may not be a productive course of action. In fact, the current environment has not supported solid recovery values in most sectors. More often than not, lenders have been willing to “amend and extend” loan terms in the energy sector, knowing that the alternative would be to attempt to sell assets into an extremely soft market—what some might call a “falling knife” market.
As in all markets, pricing depends on both supply and demand. As oil prices declined due to oversupply and insufficient demand, the market clearly demonstrated its inability to correct quickly. However, as the market price for WTI and Brent oil continued to drift lower, producers eventually adjusted to the new norm.
For example, while certainly not accomplished overnight, the industry in time experienced a significant reduction in the number of drilling rigs in operation. A year ago, more than 2,100 land-based drill rigs were in production in North America. Today the number of active land-based drill rigs is under 1,100, a reduction of roughly 52 percent. This figure doesn’t reflect changes in the number of offshore rigs, which are much more complicated to take out of production.
According to the Baker Hughes Rig Count, the number of U.S. land-based drill rigs in production rose ever so slightly in early July for the first time in more than seven months. This slight improvement was certainly based on what had been a relatively narrow range for WTI of around $60 per barrel over the previous couple of months. However, given the recent drop in WTI price of oil this data bears watching.In fact, given recent developments in Greece and their impact on the European economy, plus China’s recent currency fluctuations, some would argue that this slight reversal in drill rig utilization was premature. What is clear is that oil prices remain extremely volatile and are subject to dramatic swings. In this current environment, while macroeconomic factors such as the industrial growth rate in China are clearly key drivers, the quick drop in oil prices following the “no” referendum vote on additional austerity measures in Greece underscored the unpredictable nature of the world market for oil.
Ultimately, the volatility of the world energy markets is a well-known obstacle that any investor in the sector must accept as a condition of doing business. While there is little to be done to control fluctuations in pricing and their impact on asset values, investors can limit their risk exposure by monitoring market shifts closely and analyzing possible exit strategies based on the market environment.