Enthusiasm for Growth Diminishes in a Lingering Volatile Market
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The 2015 BDO Oil and Gas RiskFactor Report examines the risk factors listed in the most recent SEC 10-K filings of the 100 largest publicly traded U.S. oil and gas E&P companies. The risk factors were analyzed and ranked in order of frequency cited.
The U.S. energy industry continues to struggle to find its footing as commodity prices remain stubbornly low. This year’s BDO Oil and Gas RiskFactor Report, which analyzes the risk factors listed in the most recent 10-K filings of the 100 largest public U.S. E&P companies, finds that low prices are dampening companies’ enthusiasm for investing and expanding—and amplifying the potential impact of impediments to future growth.
For the first time since the study’s inception, risks related to replacing or expanding reserves is the most frequently cited threat, with all companies indicating low prices are inhibiting their ability to make key investments in maintaining supply. According to IHS, the pain is widespread, with the industry hitting a 20-year low in the number of newly-discovered oil and gas reserves in 2014. What’s more, the number of companies expressing concern about their ability to meet production minimums tripled, increasing to 36 percent from 12 percent in 2014. Amid this uncertain supply environment, 82 percent of companies also expect to experience shortages in rigs, equipment and personnel, further constraining their ability to maintain the robust production levels they had previously enjoyed. This represents a 5 percentage point jump from the number of companies citing similar concerns in last year’s study.
Accounting Risks Emerge As Priorities
Moreover, the past year’s decline in oil prices is also driving increased worry about accounting-related risks, such as maintaining internal controls and complying with accounting regulations. The number of companies citing this risk grew by 47 percent, with 84 percent of companies noting it in their 10-Ks. Should low prices continue to force companies to record impairments on their balance sheets, the impact to their financial results could be significant: Additional write-downs adversely affect not only their operations, but also their stock value—which could rile shareholders in an already-tense market. What’s more, intensified scrutiny from the SEC and PCAOB is simultaneously drawing renewed attention to more stringent financial reporting, driving E&P companies toward devoting ever-growing attention and resources to maintaining their books.
Regulatory Risks Continue to Grow
All companies analyzed continue to cite federal, state and local regulation as a significant risk in this year’s 10-Ks. However, a notable trend is emerging: Hydraulic fracturing legislation and regulation have become a near-universal concern for the industry. This year, 96 percent of companies identify fracking regulation as a risk, nearly double the number citing it in the inaugural Oil and Gas RiskFactor Report in 2011. With the Energy Information Administration reporting that shale formations produced approximately 4.19 million barrels per day of crude oil and 4.51 trillion cubic feet of natural gas in 2014, it is no surprise that fracking has become the bedrock of the industry—and that companies have, as a result, become increasingly sensitive to attempts to regulate it.
At the same time, this threat of increased oversight is causing a ripple effect among the fracking-related risks companies face. Should regulators implement greater restrictions, rendering the fracking process too difficult or too costly to perform—particularly in states like California as it enters the fourth year of an historic drought—concerns of water shortages may become an unwelcome reality. As a result, 52 percent of companies express worry about their ability to secure sufficient amounts of water required for fracking, nearly a 25 percent increase from last year.
Furthermore, the effect and environmental impact of wastewater injection and disposal techniques remain concerns for companies amid mounting pressure from policymakers and the public to either ban the practices entirely or to implement more eco-friendly procedures. For example, in March 2015, the Obama administration imposed more stringent standards on fracking operations on public lands, seeking to lower the risk of water contamination. These environmental concerns, along with those associated with more traditional drilling methods—oil spills, land conservation, wildlife protection—continue to remain top of mind for the industry overall, with 95 percent of companies citing environmental and health regulation as a risk in this year’s study.
The impact over growing climate change regulation also has companies feeling the strain in a depressed commodity price environment: 82 percent cite efforts to regulate greenhouse gas emissions as a risk this year, consistent with last year’s study. The International Energy Agency reports that, globally, nearly 1,400 climate policies had been implemented by 2013—a dramatic increase from the 200 that existed in 2005. With climate change remaining an urgent policy priority worldwide, producers are beginning to feel the effects of the fossil-divestment movement as investors cut funds and reevaluate their exposure to these regulations.
Threats to Production Remain Top of Mind
Uneconomical oil prices are not the only threat to production E&P companies face. Political conditions abroad, particularly in the Middle East, are a perennial worry for the U.S. sector, particularly as companies grow increasingly global and look to sell products to foreign markets. This year, an overwhelming majority (83 percent) of companies cite risks associated with geopolitical unrest as threats to their business, a 12 percent increase from 2014. OPEC’s refusal to curb production in the face of over-supply and the potential easing of Iranian oil sanctions and the reintroduction of their oil to the market continue to exacerbate price declines. At the same time, continued conflict in Syria and Yemen threaten to further destabilize the region, leaving the oil and gas industry uncertain as to what, if any, effects may reverberate in the sector. The industry is also keeping a careful eye on other major oil- and gas-producing countries in the midst of political turmoil, such as Russia and Nigeria.
Meanwhile, companies must also keep abreast of new and emerging risks to their business. Securing sensitive digital information has steadily grown as an important concern for companies as hackers become increasingly sophisticated and adept within today’s evolving technological landscape. In fact, the Department of Homeland Security’s Industrial Control Systems Cyber Emergency Response Team reports that the energy sector leads all others, including manufacturing and healthcare, in the number of reported cyber theft incidents in fiscal year 2014. It is no surprise, then, that nearly three-quarters of the companies analyzed cite cybersecurity attacks as a risk, up from 53 percent in 2014, 46 percent in 2013 and a mere 12 percent in 2012.
Mother Nature’s power also remains a disruptor, with 96 percent of companies mentioning natural disasters and extreme weather conditions in their 10-Ks. From the threat of brutal winters hitting major production centers to hurricanes destroying rigs and delaying offshore activities, companies remain wary of their ability to maintain production efforts and stay competitive as the United States faces increasingly severe and unpredictable weather conditions.
Hedging Risks Persist Amid Volatility
With the commodities market remaining depressed, oil and gas companies continue to use derivatives to mitigate their exposure to price declines. However, these hedging instruments are inherently risky, and a majority (82 percent) of companies cite them as threats to their business this year—consistent with the number expressing a similar sentiment last year (85 percent). In particular, companies are concerned that locking in derivatives contracts now will prevent them from reaping the benefits of a recovery in oil prices in the future. But perhaps more pressingly, E&P companies are concerned that counterparties to their hedging arrangements will fail to perform under their contracts: About three-quarters of companies cite the creditworthiness of their financial partners as a risk, jumping more than 13 percent from 2014. Additionally, 74 percent of companies also consider derivatives legislation (i.e., Dodd-Frank) a potential threat to their business, a slight uptick from 69 percent last year and 65 percent in 2013.
Alternatives Give Fossils a Run for Their Money
Competition from alternative fuel sources, such as solar and wind power, has been consistently ranked among the top risks listed by E&P companies in their 10-Ks since the inception of the Oil and Gas RiskFactor Report. This year, 83 percent of companies cite the price and availability of alternative fuels as a risk, the highest proportion in the study’s history. According to Bloomberg, as of 2013, the world is creating more capacity for electricity generated by renewables than it is for coal, oil and gas combined. As prices for this renewable energy continue to decrease downstream, and as public pressure mounts for greater investment in alternative fuels, E&P companies may need to move quickly to remain competitive. Efforts to develop cleaner and more resource-efficient processes will be critical to the industry’s ability to remain an essential component of the world’s energy mix.
Transportation Capacity Continues to Squeeze Producers
Rounding out this year’s top 20 risks, 80 percent of companies cite insufficient refining, pipeline, storage or trucking capacity as a risk, a modest decline from 2014. While producers grapple with low commodity prices and supply increases, they continue to express worry over their ability to effectively and economically bring their resources to market. Companies also view their reliance on third party-owned processing facilities and transportation as an evergreen challenge, with 77 percent noting it in their 10-Ks.
Overall, while this year’s Oil and Gas RiskFactor Report suggests that the industry remains concerned about its ability to maintain the high levels of production it enjoyed over the past several years, the market has experienced a very modest recovery in prices. In this return to normalcy, producers understandably continue to worry about risks that have the potential to jeopardize both their future operations and bottom lines. But companies who take a longer-term approach in overcoming these hurdles, and keep an eye to the horizon for innovation and new technologies, may be well-positioned to weather the storm.
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