For the oil and gas industry, reducing cost and improving efficiency have become critical focus areas for organizations centered on both conventional and unconventional well development programs. As the industry moves into second-half 2016, commodity prices continue to stay at levels that make it uneconomic for most upstream operators and their corresponding projects due to a variety of macro factors and internal realities such as planning and execution assumptions and models. The result is companies and assets in deep distress even after quick fixes such as headcount reduction and reworked vendor pricing. Pressure might be alleviated in the extreme short term, but the pattern of allowing rising prices to mask inefficiencies and waste in asset development programs will continue.

Don’t blame it on low oil prices
Let’s look beyond the reality for a moment that a large percentage of the U.S. oil and gas E&P industry is suffering an untenable moment of balance sheet distress and instead ask ourselves the following question: Are we surprised? Since 1986 the monthly crude price volatility (as measured by the monthly standard deviation) has been about 8.7%, with crude prices ranging from as low as $11.40/bbl to as high as about $133.80, according to the Energy Information Administration’s monthly closing prices for West Texas Intermediate. Over this same period the industry has observed a continued ramp-up with respect to the amount of debt financing used to fund development programs. It also is worth highlighting that crude prices increased nearly 2.5 times over a similar period during which debt capital became abundantly available, all while the underwriting parameters became markedly less stringent. In either case, the confluence of an industry with tremendous inherent operational leverage and high volatility with respect to revenues (given commodity price volatility) at all times portended negatively to sustainable financial health. The enveloping distress is more of an arrival of something we should have all been expecting as opposed to a surprise visitor.

High levels of interim crude prices masked long-term debt capacity levels, while corresponding peak-level single well economics obscured operational inefficiencies that appear to have been rampant throughout the industry. When single well rates of return are 60%, 70% or higher, management teams are rarely held accountable for potential inefficiencies that are preventing these returns from being 10%, 20% or 30% better. In the present environment, when even the best companies are having to high-grade production to keep well economics positive, preserve production levels and maintain borrowing capacity on bank lines, the impact of legacy organization inefficiencies becomes pronounced.

Becoming competitive
Organizations that find themselves faced with difficult decisions due to high debt loads and uneconomic operations have options in moving back to being competitive. There is likely universal agreement in the idea that a disorderly restructuring leads to greater economic leakage than an organized restructuring, in or out of court. Notwithstanding the merits of this “axiom,” the ability to address issues relating to operational disarray and financial duress is predicated on first acknowledging the existence of the underlying problem. In some cases, middle-sized and larger public companies have been able to issue equity to ensure their liquidity. The highly dilutive nature of these issuances keeps many companies from creating liquidity in this fashion; however, highly dilutive is a far better alternative to equity as a call option, which is what happens when that new-issue window closes and debt overwhelms enterprise value. To the extent a company can’t find a liquidity solution to bridge its capital structure, elements of an active financial restructuring process should be activated long before formal relief is required through the Bankruptcy Code.

A survey of the activities of a number of highly levered companies indicates that many such companies throughout the industry are beginning to collaborate with financial restructuring firms to address everything from strategy in an impending bankruptcy to strategic alternatives to bolster liquidity and balance sheet strength to prevent a bankruptcy. Often times, well in advance of a bankruptcy filing, these restructuring advisers will work with the companies to coordinate a dialogue with key creditors to facilitate a more orderly restructuring; these actions can in certain circumstances altogether preempt the need for a bankruptcy filing and facilitate a consensual out-of-court debt restructuring. Creditors, including trade vendors, are inclined to participate in these advanced dialogues since an out-of-court process can be a more expedient way to de-leverage the enterprise and simultaneously maximize the risk-adjusted recovery to the creditor.

Operations
Another key area that organizations should be focused on has to do with the ways in which the assets themselves are developed. Companies that are looking to shed “noncore” or uneconomic acreage or benefit from distressed assets at bargain prices need to also be thinking about the processes involved in the planning, designing and executing of the acreage to maximize potential. This involves project engineering to the acreage specifics—a combination of technology, people and process.

The data piece in reworking project design and execution can’t be overemphasized here. The ability to gather large amounts of external offset well information is available to operators in most basins. Key for successful organizations that want to change prior models for developing acreage to truly capture efficiency lies in turning that information into an externally referenced basis for subsequent design and planning. This type of analysis should include all operators in given basins, regardless of size. If supermajors (or large independents) are going to compete in onshore basins, they must acknowledge and look to the ways in which “lean” operators plan and execute. Doing so moves the mindset from measuring internally to pushing to achieve what is possible by engineering and executing to externally referenced cost and production targets.

Acknowledging basin realities through offset execution is one part of the puzzle in moving out of a distressed state. Organizations also will face a capability and talent gap as they move into the inevitable “ramp-up” phase when supplies decline and prices begin a steady rebound. The quick move to slash headcount, while appropriate in many cases, also should be measured against full-cycle exposure the company might have as it works to bring projects online. Oil and gas companies should be thinking about a combination of people, processes and technology to truly innovate ways to enhance design and execution. Technology (IT or equipment) will not realize its maximum potential unless its deployment is underpinned by the right resources and talent strategically focused and organized around efficient processes. These must all be positioned squarely around maximizing capital investment, enhancing shareholder returns and propelling the organization to the competitive basin position.

The oil and gas industry has an opportunity to begin breaking out of the historical cycles of extreme rampups when times are good to jettisoning people, delaying (or canceling) projects or even bankruptcy during the downcycles. Doing so, however, will require a combination of managing the debt cycles and driving operational efficiencies for capital projects. Those companies that are able to quickly navigate from a distressed operator with an unmanageable debt burden to a less levered but agile operator, shifting quickly from prey to predator, will swiftly expand their operations, acreage and development programs to exploit a historic trough in the industry and maintain sustainably competitive operations post-2016.

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