OUR GREAT MINDS

    by Andy Brogan

    Resilience in a Time of Oil Price Volatility

    Are we living in the new normal? There’s no shortage of speculation around the future price of oil from media and industry alike. Many believe the price slump, which began in mid-2014, could last for some time while others maintain a more optimistic outlook. But there is one thing most agree on: the price of oil won’t be returning to $100 per barrel plus levels any time soon. After all, supply is up and demand is down — and there’s no sign of that equation changing in the near future, particularly with the OPEC looking determined to stay the course.

    Though the price drop took many by surprise, it didn’t take long for the industry to respond. In early 2015, we saw deep cuts to capital budgets as well as substantial layoffs. Now, with short-term price expectations moderately low or, at the very least, uncertain, we expect to see continued reduced interest in upstream investments and greater investment risk or “hurdle rates” for new investments.

    Managing oil price uncertainty requires companies to focus on strengthening financial, portfolio, and operational resilience. Companies that adopt this approach will not only weather a lower-price environment, they’ll position themselves for even greater success when prices rebound.

    Financial resilience: Companies must learn to manage the imbalance between new levels of cash generation in a lower-priced environment and their internal and external obligations. This means optimizing capital structure, restructuring the balance sheet, refinancing certain loans if possible, and raising equity. Financial resilience also requires strong working capital, that cash balances are optimized, and that tax and corporate structures are configured for maximum benefit. It is important to review the company’s dividend structure and determine if cash flows are sufficient — at a variety of price points — to maintain existing payout levels. If cash flows aren’t at the level they need to be, the company can consider divesting assets or business units to generate cash. Understanding and managing possible impairment risks is another way companies can strengthen financial resilience.

    Portfolio resilience: Portfolio management is a crucial component of weathering oil price volatility. Companies must consider the implications and risk exposures when investment assumptions no longer hold true. Optimizing the portfolio obviously involves restructuring capital allocations away from high-cost, lower-return projects and carving out underperforming assets if necessary. For companies with stronger balance sheets, it also means considering whether to pursue strategic acquisitions to expand into growth markets. However, it also involves maintaining optionality so that companies can respond to events quickly and effectively.

    Operational resilience: Executives must gain a thorough understanding of short-term and full-cycle marginal and break-even costs, and use that knowledge to challenge operational assumptions. In the current environment, it’s more critical than ever to deliver capital projects on time and on budget. Leadership teams must be willing to take bold action, such as re-scoping, deferring, and even stopping projects that are not on track. Companies should also be transforming their business models to lower their cost base as well as renegotiating their supply chain arrangements to reduce expenses and collaboratively drive efficiency.

    While every oil and gas company can benefit from strengthening financial, portfolio, and operational resilience, not everyone is impacted in the same way. Majors continue to survive, and even thrive, viewing the new normal as opportunity to pursue affordable acquisitions. Similarly, most national oil companies are equipped to survive price fluctuations despite intense fiscal and political pressures. It’s the smaller independents, especially those that are highly leveraged or insufficiently hedged, that are most vulnerable.

    No one knows how long the conditions we see today will last or whether it is, in fact, the new normal. The only constant is that uncertainty, in one form or another, will always exist in the energy industry. Regardless of where commodity prices settle, energy executives that focus on building resilience will maintain their competitiveness and position their companies to thrive in any oil-price scenario.

    Andy Brogan is EY’s Global Oil & Gas Transactions Advisory Services Leader. He is based in London, United Kingdom. For more information and to access EY’s report, Resilience in a time of volatility: oil prices and the energy industry, visit ey.com/oilandgas.

    The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.

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