Challenges Faced by Upstream Oil and Gas Operators

 Challenges Faced by Upstream Oil and Gas Operators

Over several decades now, the oil and gas industry has been one of the world’s largest economic sectors, generating trillions of dollars in the world revenue basket. The discovery of oil and oil drilling technology made a huge boost in the world energy supply causing a ripple effect in other sectors that have the time, significantly dependent on energy from fossil fuels, to run day-to-day activities. Furthermore, the world has gradually become a crucial source of energy, as almost every other industry directly or indirectly depends on trends and events in and around the oil industry. However, in approximately a decade, there have been significant changes in this industry, especially in terms of price and its volatility. Such has given rise to enormous challenges due to risk, especially to companies dealing with production and supply of oil and oil products. This paper will focus on these challenges as well as other significant developments in the oil and gas industry that upstream oil and gas operators are facing. Also, it will include the impacts on the industry and other industries dependent on the oil industry and how different energy factors are rising to the occasion to try and offer alternatives for oil.

The global oil sector has recently been a beehive of activity. A lot has taken place, especially since the beginning of 2020. However, before we dive into the events of the year 2020, we will take a look at how the demand and supply for oil have fared recently before 2020. Then represent the information side-by-side with that of 2020. According to the U.S. Energy and Information Administration (EIA), oil production and consumption forecast across the world have significantly been disrupted in 2020 (Energy Information Administration, 2020). Even before this disruption, other than volatility in price facing the upstream oil sector, there was an expected fall in demand for oil further compared to data from the previous year. Martinsen (2019) writes about oil demand worries continuing as there has been a global economic slowdown mostly attributed to the China-US trade wars. He further indicates the expectation of oil demand growth by 0.8mn bbl./d year-on-year for 2019 down from a five year, year-on-year average demand of 1.5mn bbl./d (Martinsen, 2019). Amid unstable oil prices, we have experienced a continued increase in production, especially in the U.S. Here, shale production continued to grow amid falling and volatile prices. There have been a few numbers of upstream operators that have focused on capital discipline even though there has been a weak market sentiment, continued cash-flow constraints, and also investor skepticism (Deloitte, 2020). Therefore, the supply of oil has not quite reduced, especially among the OPEC, Russia, and the U.S, but the outlook could change entering 2020.

Figure 1: Data by EIA, 2020

Figure 2: Data by EIA, 2020

This year, adding up to information before 2020 saw a dramatic fall in demand attributing to the global health pandemic that has forced many people to shelter at home. The figures above represent an overview of the worldwide oil sector in the recent past. Figures 1 and 2 show that oil production increased at a very gradual rate. It was about 94mn bbl./d to around 100.8mn bbl./d from the first quarter of 2015 to the 4^th quarter of 2019. Similarly, over the same period, consumption has increased from about 95mn bbl./d to 100.8mn bbl./d (Energy Information Administration, 2020). Later analysis, more so in the year 2020, shows a massive fall in demand for oil and oil products. Such is highly due to numerous stay-at-home orders by authorities in most parts of the world about the Covid-19 outbreak. Moreover, lower economic growth, less air travel, and overall factors leading to falling in demand are challenges that have hit global oil markets, causing a dramatic fall in crude oil prices (Energy Information Administration, 2020). According to EIA (2020), total global oil production was 95.19 in the 2^nd quarter of 2020, representing a 5.36% shrink from the 2019 average figures. Also, global demand and hence consumption was the most affected falling from an average of 100.74mn bbl./d consumption to slightly above just 80mn bbl./d in the 2^nd quarter of 2020, which was 19.6% decline (Energy Information Administration, 2020).

The continued decline in demand and varying supply has also been associated with falling oil prices in the last decade. Oil price movements are perhaps the most crucial indicator of the performance of this industry. Investors closely watch them as well as other players who are directly or indirectly involved with this commodity. Being scarce it most countries in the world, and also being a widely essential commodity, oil differentiates with other precious commodities like gold and precious stones. For this reason, there is a high demand for oil hence making its price to be highly influenced by market forces (McFarlane, 2014). On the other hand, there is the supply side that consists of the oil producers.

On the one hand, market forces consist of demand, which is you and I who directly consume oil and its products when we fuel vehicles and, among other activities. Combinations of hundreds of millions of people worldwide, through their oil consumption, therefore, have the power to affect price movements (McFarlane, 2014) significantly. Among nations that are in the list of the world’s biggest oil producers, more so in the recent past are the United States, Saudi Arabia, Russia, and Iraq. Other countries are well known in oil production: Canada, Kuwait, United Arab Emirates, Norway, Nigeria, Angola, Venezuela, and Qatar, among others. In addition to drilling oil, there are also enormous reserves for the commodity, which factors in the supply-side equation.

The concept of demand and supply for goods and services applies such that an increase in demand and supply decreases, price increases, and vice versa. However, as much as these market forces apply, the futures market plays a significant role in determining oil prices (Kosakowski, 2020). It consists of an oil futures contract that has a binding agreement between parties such that, one can purchase oil in barrel amounts at a predefined date in the future which also requires both parties to honor their end of the deal on or before such a preset time (Kosakowski, 2020). Investors and traders in the futures market are classified into speculators and hedgers. Hedgers buy oil futures intending to mitigate against potential risks in the price hike, and they mostly consist of companies that consume vast amounts of oil in a month. Speculators are more of traders that guess price movements for oil without necessarily having the intention to buy the product at the end of the month. These two categories of traders, therefore, have their share of influence of price movements. Also, according to Kosakowski (2020), the mere belief that there will be fluctuations in demand and supply for oil buy such traders can lead to a surge or decline in oil prices. Such is regarded as price movements due to market sentiments. Either way, demand is a significant price determinant, and fluctuations have a substantial effect at the end of the day.

Factors such as location spread in the West Texas Intermediate (WTI) compared to Brent and variations in maturity, among others, are essential factors that have an influence in price only in the short term. However, in the long run, the costs of the different crudes move in tandem with each other when supply and demand factors shift (Huntington et al., 2012, p. 5). The key drivers of oil price path in the long-run, especially in the recent past, have been the performance of various economies across the world, especially in big oil-producing countries. Also, technological developments and political dispensations play a role in oil demand and supply, eventually sandwiching prices in between. Therefore, despite other factors essential in determining oil price movements, the Long-run oil price path is set out by supply and demand conditions. These conditions are in the physical market for crude oil and other products derived from it (Huntington et al., 2012, p. 6).

The recent dramatic fall in oil price whereby the futures market recorded historic lows, and the price surprisingly going into the negative, but many upstream oil dealers in a tight spot close to putting many of them out of business. Interventions by OPEC and the G20 nations when they agreed to cut production may have produced a much-needed cushion amid a crisis (IEA, 2020), but upstream companies are not out of the woods yet.  Such price fluctuation calls for significant strategic changes in navigating this industry for these companies to survive and be profitable once again. Upstream oil and gas players are the leading figures in this industry, consisting of groundwater and underground crude oil and natural gas fields and those that explore through drilling wells. Martinsen (2019) had predicted that shale companies would have a more comfortable run before then end of the first half of 2020, but with the sudden emergence of the Covid-19 health crisis, all these could end becoming hard to fulfill. Before the recent price downturns, we have had increased costs in production and storage (Marten, 2015). There was an element of growth in the industry hence some sense of optimism. However, downturns can lead to increased bankruptcies and low spending in the field of development, which is a risky matter for upstream gas companies (Deloitte, 2019). Therefore, it solely depends on the deployment of strategies that will help these companies focus on production to meet future demand and, at the same time, sustainably generate value (Deloitte, 2019).

Upstream oil companies have seen their share of challenges since the start of the epidemic, adding to price wars between Saudi Arabia and Russia in the early years. According to an article in the New York Times, Saudi Arabia and Russia helped spark the oil price collapse when they decided to increase production rather than cut it (Krauss, 2020). As a result of the two significant events, many companies are reducing their spending to accommodate costs associated with the disastrous results. Cutting expenditures looks like a short term strategy for many of these companies. In any case, if demand for oil will not improve close to levels they were before the pandemic, many of these companies will have to re-strategize. According to The New York Times, production was to fall gradually from March by a couple of a million barrels, which it did. Many energy experts believe that profit margins for several companies will shrink while others will not be able to cover their fixed costs (Krauss, 2020).

Besides cutting spending, upstream oil companies must brace themselves for these hard times and find ways to evolve through refocusing their portfolios. According to Deloitte (2020), this refocusing can lies in four factors: scale, scope, cost, and running room. Concerning scale, a company can evaluate how much oil and gas it is producing. Also, how many fields and regions. A scope defines the different types of projects and resource themes a company operates. The cost will identify how capital and operating costs stack up and whether projects are in a short or long cycle or require continuous or upfront investment. Finally, the running room is where a company would find out whether an increase in production is possible with the substantial costs as it has been off-late. If not, what are the factors that are inhibiting such an expansion (Deloitte, 2020)? Exploring these four factors could assist oil companies that are going through a rough patch to explore better ways to survive the storm, at least.

Hedging on prices is a common thing in the oil industry. Oil companies hedge as part of risk management and strategy, and they do so commonly using derivatives. According to Nyssanova (2016), Derivatives are traded over exchange-traded markets or over-the-counter markets (p. 22). Derivatives, therefore, count as individual-traded and standardized contracts that have been defined by an exchange (Nyssanova, 2016, p. 22). Past research has shown that hedging with the use of derivatives can significantly increase chances for higher firm’s value, investments, and leverage employing natural experiments and information collected from utilities (Nyssanova, 2016, p. 27). In as much as no adequate information is about the causal effect of hedging on the firm’s value, there is a certainty that derivatives have been a powerful and useful tool for hedging and shifting risks. According to Bartram et al. (2011), using a large sample of non-financial companies from 47 countries examined the effect of derivative us on firm risk and firm value by matching users and nonusers. This matching was done on the grounds of these people’s propensity to use derivatives. The results showed strong evidence that financial derivatives reduce both total risk and systemic risk (Bartram et al., 2011).

As a commodity, oil is subjected to speculation surrounding changes in price. Such leads to a weekly basis of high volatility in price, whether predictable or not (Pindyck, 2001). These speculations usually are done via the commodity spot and futures prices, whereby there is a quote for a contract. Still, the agreement between a buyer and a seller is different (Nickolas, 2015). According to Nickolas (2015), the spot price is the current quote for immediate purchase, payment, and delivery of a commodity. He further proceeds to define the futures prices for a commodity as the offer for a financial transaction that will occur on a future date. Therefore, we can deduce that the main difference between the oil commodity spot and the futures price is the date of delivery.

Since the discovery of crude oil and the ensuing developments in the oil industry, there was the invention of cars and other transport vehicles that relied and have since then relied on oil and oil products to run their engines. For more than a century, millions of diesel and petrol running vehicles and machines have been manufactured, giving rise to a whole new and wide range of industries that are primarily based on the oil industry. However, as times have changed, and developments in technology have come with more modern and better machines that maximize the use of fuel from fossils. Amid technology development in making these machines, the same has also been achieved in the oil industry where better ways to obtain crude oil have been discovered. At the same time, the car manufacturing industry has grown exponentially as many people now own vehicles. With an increase in the number of vehicles and industrial production that use of fossil fuels, there have been increasing concerns about climate has been negatively impacted.

Therefore, it has necessitated the discovery of ways to help reduce the rate of pollution due to the use of oil and oil products. By the year 2017, it was estimated that there were close to 1.4 billion motor vehicles globally (Davis & Boundy, 2020). Also, China leads the world in the number of cars and the rate of pollution. The 1.4 billion mark does not, however, account for the amount of slightly above 116 million vehicles sold in 2016 that did not depend entirely on petrol or diesel that contributes to high pollution. Therefore, innovators are actively trying to invent cars that do not have to depend on fuel from crude oil. The need to save on fuel costs and adhere to rising social demand for a cleaner world has made the demand for electric cars to rise (Domm, 2018). According to A study done on the city of New York about the extent of pollution due to car exhaust fumes, found that all on-road mobile sources in the NYC region contribute to 320 deaths and 870 hospitalizations and emergency department visits annually within NYC due to exposure to fumes (Kheirbek et al., 2016 ). The data also showed trucks and buses accounted for the largest share of such pollution. Therefore, the trend is to try and reduce pollution, mainly by encouraging people to embrace electric-based vehicles, which, even though it seems attractive, has not hit the ground accurately (Coren, 2019). There have been over-ambition by investors in theses field, but there is still much to be done. However, there are issues such as the recent plummeting of demand for oil, and the encouraging news from scientists. They monitor climate change; about the effect that lack of too much vehicle activity due to stay-at-home orders has led to electric car technology may continue to threaten the oil industry.

The oil industry consists of one of the most essential and dependent sectors all over the world. There have been a lot of discoveries in and around this industry from drilling, fracking technology, extraction, and refining. Over time, this has given rise to very many companies that are allied to production and processing oil and oil products. Oil, despite its high demand across the world, is considered a commodity, and it is prone to fluctuations in price. However, some factors affect such price fluctuations, including application and supply, the economic performance of nations, politics, and market sentiments. The recent price wars between Saudi Arabia led to an oversupply of oil across the world, which coincided with a drastic fall in demand for the same hence leading to plummeting in price. However, an agreement to cut production stabilized the prices. However, upstream oil companies were left in a tight situation due to these falling in price and will need to develop strategies such as objective hedging (use of derivatives) to mitigate such price actions. The future of crude oil demand and supply seems as if it will continue to be harmful because of concerns in climate change and need to reduce costs associated with fueling vehicles. Such is because of the increasing manufacture of electric cars and the embrace of the public across the world. Developing policies by organizations such as the United Nations purposed to reduce pollution due to fossil fuels as a challenge for this industry in the years to come.

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