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Managing Risk of a Crude Oil Downturn

Sar Malik
March 9th, 2021 · 3 min read

The economics of the Oil & Gas sector have never been more challenging. We’ve identified the core steps that companies can take to prepare and manage the expected outcomes of cost-over-revenue base production.

The past year of sustained low trade values as measured by $WTI crude, Canadian Natural, Brent, among other selects, has resulted in many executives across the industry bracing for a sharp downturn. The question of when and where to act has been a perennial dilemma for oil and gas corporations. The market’s sensitivity to price volatility has become of paramount concern raising questions of when and when not to act, when and where to curtail capital expenditures, when to defer production outputs.

In this article, we consider the strategic implications of a downturn and how companies can more effectively prepare for and adapt to an extended period of volatile prices, as well as the steps that executives can take to become more resilient and efficient thought leaders in a difficult environment.

Context of change in a dynamic environment

The recent collapse of the global equity markets is commonly attributed to a period of health-driven economic contraction.

Beginning in Q1 of 2020, we saw the sharpest drop in energy and commodities prices and a broad-based decline in economic activity.

However, the direct effects are much less clear. At the end of the great recession of 2008, many companies were already financially prepared for continuous investment in energy independence, led on by historically low interest rates, while many others delivered strong fundamental results. While companies also had an abundance of cash, thanks to the asset boom prior to the collapse, there was considerable political uncertainty in whether an American-based energy economy would come to fruition.

In the current context, Oil & Gas sector operators (such as oil well, drilling rig, and supply chain handlers) are no longer well-prepared. There’s a fundamental issue at play.

”— Operators do not know how to maintain solvency when prices are low, when to allocate investment when prices are highly volatile, or how to operate in an environment worse than before the crisis.”

The strategy for American energy independence, combined with historically low interest rates created the opportunity of record-large capital raises, primarily secured debt packaged in CLOs (collateralized loan obligations). Exchange-traded funds (ETFs) which contain sector exposure to Oil & Gas commodities or equities such as $GUSH, $USO and $USC are down between 73% through 93% (blended average percentage points over T3M).

Operators may be reluctant to cut costs or delay capital spending, or to invest in riskier regions or brands for diversification. Segmented away from primary business activities has a potential cannibalizing impact to their brand equity by cutting direct crude service supply chains.

As historically experienced, companies with investment allocators driving operational decisions, often tend to make choices during a stage of economic volatility that positions them for sustainable growth coming out of the turmoil. Those that act now can minimize the damage and emerge from the storm with market-leading competitive positions.

Preparing for Downturn Risk Exposure

It’s imperative to develop strategic plans for managing the risk outcomes of a downturn event, even before the crisis materializes. Often preparation is done by making various contingency orchestration scenarios, many of which have a positive impact on the company’s financial position by exposing underlying risk.

Diversification and ecosystem management.

Identify opportunities in existing portfolios, hedging financial and strategic positions, and preparing for a downturn by developing infrastructure over a longer period of time.

Partnership liability risk

Formulate long-term contingency plans by preparing for a downturn and engaging in deep structural analysis. This includes both the operating model and players in the supply chain that may expose the business to risk.

Revenue optimization and cost efficiency.

By reducing sales and marketing costs, trimming overhead, and redirecting efforts to core business activity - the foundational core can be maintained through turmoil.

Profitability and efficiency.

Develop a range of strategies they can apply to maximize profits in a downturn. This may include leasehold operations of oil storage facilities, providing expertise and advisory to market players facing risk, or leveraging cloud service providers to lift-and-shift the most costly IT expenses.

Contractual obligations and transition costs.

Restructuring commitments with customers, suppliers, and logistics providers, can serve to defer cash outflow for instance. Term agreements may also contain conditions specific to resuming operational activity, such as assurances for service levels and volume discounts.

Forming compliance policies from this experience

In the ideal case, developing a 360-degree perspective and budget that they can be readily applied to stop costs from mounting, or setting up a fund to isolate critical projects can serve to establish long-term benchmarks. The outcomes from actions taken today will be even more important to combat similar situations in the future.

Companies that prepare for a downturn often do so only after it actually starts. As with current oil prices, the spike in Bloomberg sector bankruptcies, highlights the critical importance of ensuring actionable playbooks for any operating condition.

As the global conditions shift towards clean energy adoption at an accelerating pace, the Oil & Gas sector faces long-term threat of business continuity. Effective management of risk and establishing compliance policies for future activities will be critical to ensuring suitable long-term development of US energy independence.

Get in touch to learn how we can deliver a tailored strategy applying data-driven insights to provide your team with a comprehensive perspective of risk.

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