BDO 2016 Energy Outlook

January 2016

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“2015 was a difficult year for the U.S. energy sector as we exited the boom period and entered a bust phase. Though the industry has historically been able to bounce back fairly quickly, the duration of the current price decline is forcing companies to step back and identify ways to survive with fewer resources at their disposal and no clear end in sight.” - Charles Dewhurst, leader of BDO’s Natural Resources practice


Energy Industry Anticipates a Rocky 2016

The U.S. oil and gas industry experienced extraordinary stress throughout 2015 as oil prices fell by nearly 70 percent from their June 2014 levels. But according to BDO’s 2016 Energy Outlook Survey, energy CFOs are expecting still more difficult times ahead.

On January 15, 2016, Brent crude closed at $28.96 per barrel—its lowest point since February 2004—following a year of global oversupply, anemic demand and turmoil among major oil-producing countries worldwide. With no relief on the horizon, it comes as little surprise that 60 percent of energy chief financial officers (CFOs) expect changes in oil and gas prices to be the single most important factor dictating whether the industry recovers in the coming year—more than double the number expressing similar sentiments in last year’s study, when CFOs were more cautiously optimistic that prices would recover and stabilize by the end of 2015. Meanwhile, 85 percent of CFOs say low oil and gas prices will be their greatest financial challenge in the coming year.

Low oil prices have forced a number of upstream energy companies to reassess their current portfolios and make strategic cuts in an effort to save. As oil giants like Shell and Statoil announce plans to abandon major drilling projects, and with U.S. rig counts falling 62 percent from their January 2015 levels, more than half of the CFOs surveyed (53 percent) say they have experienced project terminations or delays in the past year. This is up from 27 percent in last year’s study and is the highest proportion reporting cancellations since the last industry downturn. Of those respondents experiencing project disruptions, an overwhelming majority (96 percent) cite poor project economics as the leading cause.

 “It’s possible that we may see oil prices slide further before bottoming out. China’s economic downturn and the subsequent devaluation of the yuan, in concert with the strengthening U.S. dollar, continue to drive price volatility. Renewable and alternative energy sources are also impacting the oil and gas market, as oil-dependent countries review their energy strategies in light of new regulations and political pressure.” - Joshua Lefcowitz, managing director with BDO Consulting’s Valuations & Business Analytics practice


Managing Supply Will Be Critical to Industry Right‑Sizing, but Demand Must Also Rebound

A glut of supply in recent years has been the primary catalyst of the oil price rout, and the recent end of the United States’ crude export ban threatens to further upend international oil markets. CFOs believe that a cutback in supply is imminent as the industry seeks to prevent further price declines. Forty-three percent expect the domestic supply of oil to decrease in the coming year—a nearly threefold increase over the number expecting declines in 2015—and 17 percent plan to decrease their own exploration activities in an effort to improve profitability. And as OPEC continues its game of oil price brinksmanship by flooding the market with supply, 41 percent of CFOs say the organization’s actions will be the foremost influencer of commodity price volatility in the next year.

But oversupply is not the only factor exerting downward pressure on prices. Demand is also expected to weaken in the coming year, with only 28 percent and 38 percent of CFOs saying global and domestic oil demand, respectively, will increase in 2016. This aligns with the International Energy Agency’s prediction that global demand will grow by just 1.2 million barrels per day this year, about one-third the growth rate experienced in 2015.

Continued economic uncertainty appears to be the main driver of softened demand. Fifty-six percent of CFOs say they feel worse about the U.S. economy and its impact on demand for oil and gas products in 2016, in contrast to last year when nearly two-thirds felt better about economic conditions.

Oil Supply & Demand Projections Weaken


Pricing and Supply Pressures Extend to Natural Gas

While the crash of the oil market remains top of mind for the industry, CFOs are also carefully watching natural gas inventory and prices. Oversupply, volatile prices and unpredictable winter weather are squeezing natural gas producers, too, with delivery prices on the New York Mercantile Exchange generally hovering around $2 per million British thermal units. As a result, only 40 percent of CFOs expect the domestic supply of natural gas to increase in the coming year, a decrease of 38 percent from last year’s survey (64 percent).

Nevertheless, the industry is somewhat optimistic that demand will continue to be robust as natural gas remains a cleaner alternative to oil and coal products, and as the U.S. begins exporting liquefied natural gas (LNG) abroad. Forty-six percent of CFOs believe global demand for natural gas will increase in the next year, and more than half (54 percent) say domestic demand will grow, as well.

Natural Gas Supply & Demand Projections Taper


Industry Expects a Fire Sale on Distressed Companies and Assets

CFOs’ prediction that low prices would drive increased M&A activity in 2015 did not quite come to pass as sellers held out hope that the industry would turn around and valuations would increase. However, many companies holding onto distressed assets may now be looking to clear them from their balance sheets. This year, 75 percent of CFOs expect M&A activity to grow, up from 56 percent last year. Deal pace has already started to pick up, with industry giants like Schlumberger and Shell acquiring smaller rivals who have been struggling in the tumultuous pricing environment. Unsurprisingly, just under half (49 percent) of CFOs believe undervalued oil and gas assets will be the primary driver of transactions as larger companies and investors home in on beleaguered companies seeking to shed expensive-to-operate properties and business units.

The energy sector’s increased pessimism about their ability to access capital and credit may also catalyze deal activity in the months to come. The percentage of CFOs who feel worse about their company’s access to capital has more than doubled, from just 20 percent in 2015 to 45 percent this year. During October 2015’s debt redetermination period, many heavily indebted exploration and production companies saw reductions in their borrowing bases, which has already produced operational impacts: Forty-five percent of CFOs experiencing project delays or terminations over the past year cite lack of capital as a leading cause.

With debt financing becoming increasingly challenging for energy companies, many are increasing their reliance on private equity to keep afloat. Fifty-five percent of CFOs surveyed say they are likely to utilize private equity as a source of outside capital in the coming year, up from 50 percent last year and 40 percent in 2014. For their part, private equity firms view the current marketplace as an excellent opportunity to deploy capital and pick up inexpensive assets—and reap the rewards when oil prices rebound.

“Many private equity firms are well-positioned to help energy companies navigate the current downturn, but management teams should understand that PE investment is not guaranteed salvation. Generalist PE funds may lack the industry expertise necessary to effectively manage the investment, while more experienced funds with the capital to invest in high-quality assets may be unable to justify continued drilling programs in a low-price environment. One option E&P companies may want to consider is a joint venture model that aims to benefit all parties when commodity prices rebound.”Brad Ross, director with BDO Transaction Advisory Services
 

Regulatory Concerns Persist as the General Election Approaches

Despite the energy sector being among the most regulated in the United States, market turbulence appears to outrank regulatory worries on the list of CFOs’ concerns. This year, 22 percent say legislative and regulatory changes will be the most important factor inhibiting industry growth, only about half the proportion of CFOs feeling similarly last year and the lowest that figure has been in the study’s history.

Even concerns about environmental regulation have waned. About one in five CFOs cite environmental regulatory compliance as their top focus for risk reduction activities in the coming year, compared to 61 percent a year ago. At the same time, of the CFOs reporting project delays over the past year, about one-quarter say the interruptions were caused by federal or state environmental regulations—down from 81 percent last year.

And although 37 percent say mitigating the impacts of hydraulic fracturing will be the main focus of their environmental stewardship activities this year, investments in environmentally friendly exploration and production technologies have grown less feasible for many companies: Just 22 percent of CFOs plan to devote more resources to this area over the next 12 months, down from 35 percent in 2015.

But regulatory and legislative hurdles have not completely exited the picture. When asked about their leading political concerns in 2016, nearly one-third of CFOs said that the upcoming Presidential election worries them most, approximately double the number expressing this concern last year. Meanwhile, 29 percent cite more restrictive government regulations, down from 38 percent last year. Changes to the tax regime also persist, with 57 percent of CFOs naming the intangible drilling costs deduction the most important tax issue they face in the coming year.

“Though concerns surrounding the regulatory environment nominally declined this year, the uptick in anxiety around the general election highlights continued uncertainty throughout the industry. The Obama administration has put numerous stakes in the ground on energy policy, from incentivizing alternative energy production to rejecting the Keystone XL pipeline, but it remains unknown which policies and regulations the next administration will affirm, reject or introduce.” Clark Sackschewsky, partner with BDO’s Natural Resources practice


Companies Reevaluate New Investments

Across the board, the CFOs we surveyed indicated that they are rethinking all of their expenditures and making difficult choices as to where they can stretch their dollars furthest. Despite the Obama administration’s decision to permit offshore drilling in the Arctic and Atlantic last year, only 1 percent of CFOs say they will be increasing capital investment in offshore exploration in 2016, down from 6 percent in 2015. Meanwhile, the number of CFOs planning to increase investment in non-conventional plays dropped from 47 percent last year to approximately one in three CFOs this year.

Despite CFOs’ general conservatism toward investment this year, there still may be some longer-term bright spots for the industry. Interest in Latin America’s growing natural resources industry—in particular, Mexico’s liberalizing energy sector and Argentina’s emerging shale plays—remains robust. U.S. companies are evaluating investment opportunities in these areas now in the hopes that they will later reap the benefits once the global commodities market stabilizes. Companies may also see future opportunities in crude oil and LNG exports as the United States looks to increase its share of the global oil and gas trade.

Appetite for Investment Declines


Staff Cuts Loom as the Industry Seeks to Rein in Labor Costs

Contracting prices are also forcing energy companies to scrutinize their labor costs. Seventy-one percent of CFOs hope to keep staffing levels consistent with last year, and 9 percent of CFOs say they are likely to reduce their labor force in order to increase profitability, up from 1 percent last year. Those employees who do survive the cuts are likely to personally feel the impact of tightening budgets: Fifty-seven percent of CFOs expect employee bonuses to be smaller for fiscal year 2015.

 “Executives must balance the need to bring costs down with the very real risk that a large reduction in labor force may catch them on the back foot when prices begin to climb again. The industry is threading this needle for now by effectively implementing a hiring freeze, but if prices remain low for much longer, more companies may need to seriously evaluate reducing their headcount.” Jim Willis, senior director of compensation consulting with BDO Global Employer Services
 

Wind Continues to Dominate the Alternative Energy Conversation

Energy CFOs continue to believe wind power will be critical to the global energy mix, a trend this study has observed since 2010. When asked which form of alternative energy will contribute most to the world’s energy needs in the next five years, a plurality (37 percent) point to wind, followed by solar (25 percent) and biofuels (20 percent).

Alternative Fuels Expected to Contribute Most to Future Energy Needs

2015 was a trying year for the energy industry, but it may have prepared the sector for a more difficult 2016. Companies who had hoped the current downturn would be short-lived are now being forced to streamline their operations and take a longer view of how they will take advantage of the boom times in order to endure the inevitable busts. Those who survive, though, will be well-poised to lead the industry into the future.
 

The BDO 2016 Energy Outlook Survey is a national telephone survey conducted by Market Measurement, Inc., an independent market research consulting firm, whose executive interviewers spoke directly to CFOs at 100 U.S. oil and gas exploration and production firms. The survey was conducted from September through November 2015.

For more information on BDO USA's service offerings to this industry, please contact one of the following regional practice leaders: 

 

Charles Dewhurst
Houston

 

Jim Johnson
Dallas


 
Kevin Hubbard
Houston
  Rafael Ortiz
Houston

 
Richard Bogatto 
Houston
  Clark Sackschewsky
Houston

 

Tom Elder 
Houston

 

Chris Smith
Los Angeles


 

Vicky Gregorcyk 
Houston

 

Alan Stevens 
Dallas


 

Rocky Horvath
Houston

 

Jim Willis 
Houston