Building a durable oil and gas company

The U.S. fossil fuel industry has been in turmoil for years due to changes in supply and demand as a result of an abundance of oil and gas from fracturing. These market changes occurred long before the COVID-19 pandemic struck a year ago, causing extra pressure on the industry as demand plummeted.

Despite projections that nearly all the United States will be vaccinated by year’s end, the forces driving the industry downturn will still be present. The industry continues to experience supply and demand dynamics that result in meager commodity prices. Oil and gas companies are under increased pressure to reduce carbon dioxide emissions to address climate change, as well as pressure from Biden’s American Jobs Act plans to direct funds to clean energy projects. With these factors likely to continue, a company should consider making some key strategic decisions to ensure its durability and to maximize its value for stakeholders.

Setting your strategy

To succeed in current oil and gas markets, successful exploration and production companies need to include strategy development as a critical ongoing process. For example, analyzing commodity-price fundamentals is a challenge, that requires executive teams to constantly re-evaluate where to invest their time and treasure. Companies in the oil and gas industry cannot perform strategic planning only every few years, but instead must make it a part of their daily decision-making. Oil and gas executives need to change their capital allocation processes to move at the pace of their changing strategies.

A traditional way to start an evaluation is to compile an inventory of strengths, weaknesses, opportunities and threats that face both your company and your industry. Operators should evaluate their oil and gas holdings based on several factors, including scale, scope, cost and ability to execute.

“In a non-traditional, yet increasingly common approach, executives are looking outside their respective industry and gleaning insights around trends in customer behaviors, new business models and emerging technologies,” said Chris Smith, national managing principal of Strategy at Grant Thornton. “Seeing how other industries are finding ways to monetize existing assets in new ways is top on the priority list of leading executives.” Both of these approaches to strategic thinking can help clarify your business’s existing competitive position so as to allow you to start to develop a plan for how your company will address the continuing changes the industry will face.

Making a company’s culture align with its new strategy will become ever more critical. Employees of a company typically invest not only their time but their expertise and creativity to various projects, a sense of personal interest that is often encouraged by a company’s culture values. Consequently, it is not always easy to scrap a project because it does not fit a strategy based on today’s metrics.

Loretta Cross, a managing director at Grant Thornton that specializes in oil and gas restructuring, said, “The sense of ‘ownership’ that company stakeholders can feel to a particular project will have to be overcome. This is best accomplished by forging a strong connection wedding the stakeholders to the new strategy that shows them a path to a stronger company.”

Use of scenarios and complex modeling

Successfully managing challenging price dynamics and the current regulatory environment requires tools ranging from short-term cash planning to rigorous long-term monitoring of supply-and-demand expectations. Large oil and gas companies such as Shell, BP and ConocoPhillips have all embraced scenario planning, and smaller independents must follow suit to be able to remain viable in the current environment.

Scenarios represent plausible potential future states of the industry and the company. Scenarios can be used to fuel the strategic planning process and to prepare the annual budget. Scenario plans help a company:

• Appreciate external factors that impact the company and assist in the identification of risks and to help formulate mitigation plans
• Examine the robustness of their business plans in different business environments
• Communicate risks appropriately across the organization and to stakeholders
• Make thoughtful decisions on how to position the business to respond as technologies and markets evolve, to take advantage of opportunities that meet risk-and-return criteria and to prepare for emerging regulatory changes

“Your scenarios should always include a look at how you can operate at the bottom of a down cycle,” said Cross. “In today’s environment, it is imperative to have a plan to trim back operations quickly if the market changes. The more rapidly an oil and gas company responds may just make the difference in making tremendous gains in an upswing or surviving the cycle when prices dive.”

It is often hard for smaller oil and gas companies to have the staff and resources to provide the modeling required for these complex scenarios. But it is well worth the expense to either add the resource or obtain the service from an outside source. Without this kind of planning, companies will not be able to react rapidly as the industry dynamics shift.

Operational improvements

Operational improvements in the oil patch will be driven by continued use of technology to drive results. Building digital capabilities will drive operational performance through streamlining processes and providing continuous data for analytics. Analytics will allow companies to enhance planning processes, improve production, enhance safety outcomes and reduce headcount. Energy digitalization should be a strategic priority for the organization of the future as it enables remote operations and drives human-machine collaboration. Digitalization also can have a role to play in setting near-term emissions targets, using standardized and credible reporting and tracking accountability across the company.

Shared costs for capital assets have been a staple of the oil and gas industry for years. Companies share gathering systems, wastewater systems and processing plants. It is time for companies to look for new ways to share indirect costs in new ways, whether through outsourcing, joint ventures or shared contract employees. Through the COVID-19 economic downturn, companies have learned to manage their businesses remotely, proving that having an employee full-time in an office may not be necessary. This frees management to think about new methods of getting the same quality of service through shared services.

Investors, bankers and regulators are pushing the upstream oil and gas industry to address lowering its carbon footprint. If the industry does not respond, they will have constraints put on them that could impact their long-term profitability. John Baumgartner, a managing director in Grant Thornton’s Houston office, suggests that each company should take a hard look at its own footprint. They would benefit, Baumgartner said, by finding ways to reduce gas leakage to the atmosphere, eliminating or reducing routine flaring and delivering that gas to the market. They should also look to integrate renewable sources of power at remote production facilities and low carbon electricity into new midstream and upstream developments. .

Managing the capital structure

One of the biggest questions for any oil and gas company is determining what the right capital structure is for the company. Over the past 20 years, the median debt-to-capital ratio for independent oil and gas producers has ranged from a low of 28.5% in 2005 to a high in 2020 of 48.8%. The chart shows that, prior to 2010, the trend was to reduce the debt load. However, after fracturing became commonplace, the industry funded its capital needs with debt. This increase is even more disturbing considering that companies with over $175 billion in debt have filed for bankruptcy since 2015, according to the Haynes and Boone Oil Patch Bankruptcy Monitor. These bankrupt companies either restructured their debt or sold their assets to a more financially stable owner.

The high amount of debt that the industry is carrying indicates that there are more companies that need to reduce their debt loads. For oil and gas companies, that means management has to find a balance between using limited capital for debt repayment and new investment in the development of oil and gas reserves to be a company with long-term viability. Management of these companies will need to include debt adjustments as a part of their strategy.

According to Baumgartner, “Management should consider the sale of non-core assets, debt-for-debt exchanges, debt-for-equity exchanges, and reducing investments in new developments to reduce debt.”

Each company will need to determine the right structure for them based on both their strategy and asset base. For example, the shale industry has been hit particularly hard as reserves (and borrowing bases) have dropped by about 50%, reducing the amount of capital available from reserve-based lenders and lenders have lost interest as they have experienced the steep decline curves that, absent strong drilling programs, lead to reduced reserve bases . After determining the best approach for the company, management should work with key stakeholders to execute their plan to reduce debt. Each entity will have a different set of options or tools they can use to reduce debt and improve liquidity. “It often helps to have someone from the outside help management with exploring their options,” Cross said, “as it is often difficult to see the picture completely when you are right in the middle of the situation.” Another consideration, Baumgartner offered, is that “it can be beneficial for companies to have having a neutral, independent adviser present analyses and alternatives to lenders and investors.”

Buyers’ market

The major oil companies have announced their commitment to smaller carbon footprints. Many of them plan to shift from investments to renewables and carbon capture technologies. It is uncertain whether industry giants will ever be active again in executing major acquisitions. In addition, they may announce their own divestitures of assets that no longer fit their strategy.

During 2020, there were major bankruptcies where no buyers were found, and lenders such as Citigroup were forced to join the ranks of oil and gas operators through the companies, they set up to hold the assets until the market stabilized. In addition, the M&A market for oil and gas was slow in 2020, as there were no takers for the troubled industry. As a result, there is an anticipation that there will be an active market of sellers looking for buyers.

With this as a backdrop, operators that have mastered the ability to be low-cost producers or which have capital backing may find some really good properties to buy. Before starting that process, companies must know their own strategy and their direction or rationale for the acquisition. It helps to establish the criteria that you are focused on including target size, location and profitability.

By doing this early, you take personal feelings out of the decision-making process, Smith said. The acquisition process is made easier the more thoroughly the criteria is established – it acts as a filtering process, he added. From there, a company can choose advisors and conduct diligence evaluations to create a stronger company. But company executives shouldn’t forget to listen to their gut, and should walk away if the deal is not right. After all, it will be a buyers’ market for the next year or two.

On the reverse side, maximizing a company’s value for a sale first requires a good understanding of what the market is looking for and how the company will be valued. It is best to get a valuation or market assessment from professionals. In addition, making sure the records are “cleaned up” can help a company get through the due diligence process more rapidly. For example, a company should apply reserves against old accounts receivables and take an extra look at the land records to head off any title issues. “To speed up the transaction and preserve the seller’s value, I would recommend focusing on normalized EBITDA and how working capital should be treated at settlement”, said Kyle Reid, a partner in Grant Thornton’s Houston office. “A seller and investment bankers get worn down negotiating purchase price and often give back value in the working capital settlement.”

When selling only a segment of a business, a company should separate its books to show the operating capabilities of those assets on a stand-alone basis. Company leaders should clearly understand the reasons for wanting to divest and be prepared to crisply explain that to buyers. Hiring the right advisors, ones that will bring the right buyers to the table for the type of transaction you are contemplating, can be a winning strategy. A local investment banking boutique or a large money center bank will have very different relationships.

The oil and gas industry still has some significant hurdles before it. But with the right strategy, planning, operations and capital structure, it is possible to build a company that will be durable through the coming changes.

“The secret to creating shareholder value in oil and gas,” Cross said, “is to embrace where the industry is and to change your strategy to win — not only in the current environment but also long-term.”