A predictable shock but an uncertain future
Rapidly plunging oil prices—at the time of writing below $60 per barrel—shocked the global oil & gas industry. Although many did not see the price collapse coming, the fundamental changes in supply and demand that caused it were already manifest in early 2014. Going forward, structural changes and disruptive trends will exacerbate the challenges facing the industry and could lead to a significant shakeout.
Facing one of the many crises of his time, Sir Winston Churchill supposedly quipped: “Never let a good crisis go to waste.” The remark was meant to identify a crisis that demanded immediate and thoroughgoing change. Over the intervening years, the phrase has been used by statesmen and business leaders as a rallying cry to regroup, revamp and reinvent. In this article, McKinsey continues that tradition by applying a keen lens to the oil & gas industry’s fundamentals and the needed business changes the shifting fundamentals imply. This crisis is an opportunity for the industry to significantly reshape how it works.
The oil price shock was predictable
Harbingers of the current collapse of global oil prices were already visible in early 2014 on both the supply and demand side of the equation. In fact, during the past year our clients have focused increasingly on the implications of low oil prices.
From the demand perspective, OECD oil demand peaked in 2005 and has subsequently declined by nearly 10 percent. The Chinese economy, which drove half the net demand growth since 2005, has slowed down. In addition several megacities in China have imposed or are considering restrictions on car purchases. The EU economic slowdown in the third and fourth quarters dragged demand down even further. In response, the International Energy Agency (IEA) cut its outlook for growth in petroleum demand from 1.4 to 1 percent annual growth (between June and September). Although economic conditions in China and the EU contributed equally to the 2014 revised outlook, petroleum demand growth in China slowed more than expected (from 6 percent to less than 3 percent annual growth between 2009 and 2014, according to IEA figures), and the EU recovery did not materialize.
While demand fell, supply grew well beyond expectations. US light tight oil (LTO) production was a major contributor. Throughout 2014, US production exceeded projections by more than one million barrels per day. At the same time, Iraq and Libya boosted production by 200 and 300 kboed respectively at different points in the year. By August, US LTO and Libyan production were increasing the global oil supply by 1.3 mbd above projected levels. Although forecasting Libyan and Iraqi oil production is difficult and complex, growth in the LTO supply was fairly predictable. McKinsey’s Energy Insights has been forecasting 2014 daily LTO production of about 3 mmbd (2.9 to 3.4 mmbd) since 2012.
Uncertainty and disruption in the future
Supply and demand uncertainty will continue. The US LTO revolution, for example, is picking up speed and has already exceeded most 2014 industry projections. On its current trajectory, US LTO production could reach some 7 mbd by 2020, with an additional potential of approximately 1 mbd with favorable subsurface quality (Exhibit 1).
Although some speculate about OPEC’s intensions to maintain production quotas to pressure LTO producers, evidence suggests that current actions may slow but not thwart LTO production. At $60/bbl crude oil, we estimate that over 60 percent of production from new wells will be economic. Experience indicates that it can take up to eight months before drilling activity responds to price declines. US oil rig activity, for example, only dropped slightly in the weeks following the sharp oil price decline in October—from 1,600 to 1,575 actively drilling oil rigs reported by Baker Hughes.
Despite the profitability of LTO, its growth could be limited by cash constraints. Independent players are more heavily leveraged than they have been in recent history. Investor opinions vary greatly about whether independents will have sufficient access to debt markets in order to maintain current growth rates. Majors are also cash-constrained. Ramping down LTO and onshore production may be more cost effective and less disruptive than ramping down deepwater production.
Geopolitical factors compound uncertainties in supply and demand. The Ukraine-Russia crisis, sanctions against Russia, the dispute in the East and South China seas, and conflicts in Iran and Iraq are some of the many situations creating uncertainty around much of the global petroleum supply.
In addition, radical reductions in the cost of renewables make some technologies profitable in certain uses and settings, affecting gas-to-power in the short and medium term, but potentially oil-to-transport in the longer term. Emerging technologies including electric vehicles, car sharing, and driverless cars could further disrupt the structural dynamics of global oil demand. In addition, new fuel efficiency standards (eg, CAFE) and a real push in the automotive and aerospace industries to increase fuel efficiency will also affect demand.
The state of the industry—a decade in the making
The fact of the matter is that the oil & gas industry had been underperforming the market since the credit crisis—long before the recent plunge in oil price. Majors and independents have been under investor pressure and the recent price collapse is shaking investor confidence further in an industry that has been marked by missed growth targets since the early 2000s and declining returns on investment during the last several years.
Capital markets’ deteriorating confidence in the industry is reflected in lower total returns to shareholders versus the S&P 500 during price declines in 2008 (13 percent for the petroleum industry versus 18 percent for the S&P 500) and recovery after 2009 (17 percent versus 23 percent, respectively). Declining enterprise value (EV) to invested capital (IC) ratios since 2008 is further evidence of capital market concerns.
Declining returns on invested capital (ROIC) have been lowering valuations across the industry. As of June 2014, the ROIC of majors has dropped to 9.4 percent, a precipitous fall from its 2006 peak of 20 percent and the lowest ROIC since 2002 (Exhibit 2). Net capital expenditure as a share of operating cash flow has nearly tripled since 2005. The leap hampers the ability of companies to generate free cash even when oil prices are above $100 per barrel.
For independents, the enterprise value to invested capital ratios has not dropped as much as for majors, as industrywide decline in ROIC was offset by stronger growth expectations.
For more, download the full paper from which this article is based, Never let a good crisis go to waste (PDF–687KB).