Interview: Why This Oil Downturn Is ‘the Perfect Storm’

[Editor's note: A version of this story appears in the June 2020 edition of Midstream Business. Subscribe to the magazine here. It was originally published June 1, 2020.]  

The University of Oklahoma (OU) campus sat unusually quiet for an early spring day. OU’s spring break had come and gone; the sidewalks should have been swarming.

But OU, like other educational institutions, closed its physical operations as the first quarter ended due to the COVID-19 crisis and turned to the internet to continue instruction. Dr. J. Mike Stice, dean of the Mewbourne College of Earth and Energy, apologized as the conversation began for cutting the meeting short; he had to prepare videos for two of his classes that he now teaches remotely. Work goes on, pandemic or no pandemic.

Stice knows energy in general—and the midstream in particular—very well. He was in corporate senior management in the U.S. and abroad for more than 30 years before moving to his education role in 2015. He held senior posts at ConocoPhillips Co. and Chesapeake Energy Corp. before serving as CEO of Access Midstream LP prior to its acquisition by The Williams Cos. Inc. Currently, he is on the board of directors of Marathon Petroleum Co. and MPLX, among other business and charitable functions.

He took time from his schedule to share with Midstream Business what he sees occurring now in the oil and gas business and what may lie ahead.

MIDSTREAM BUSINESS: The oil and gas industry has been through downturns before, but this one feels different. Is it, and if so, why?

STICE: I don’t think it’s typical. What we might normally see in a downturn is that there’s some event or economic shock that basically reduces both supply and demand. Or we’ll see something that causes a boom, then we’ll see increases in both supply and demand as the markets try to find the new equilibrium.

But in this case, it’s kind of the perfect storm. We have simultaneous supply and demand shocks—oversupply and loss of demand at the same time.

Normally, supply and demand shocks tend to be congruent. In other words, whatever the shock is to the economic environment, it will be driven from either supply or demand but rarely both. As an example, an increase in supply will create downward pressure on price, resulting in the demand absorbing the incremental supply. In today’s case, you have this very unique circumstance where you have an oversupply driven by the shale boom, the Saudi response and the Russian response, and at the same time we are experiencing a demand reduction related to the coronavirus. The huge reduction in activity, which has refineries down 30% because there’s no refined product consumption, is just one example of further downward pressure on global commodity prices.

You can talk about the other commodities—natural gas and NGL—a little differently, but there are challenges there, too.

MIDSTREAM BUSINESS: Is this just part of the industry’s usual cycle, or has the industry fundamentally changed?

STICE: I believe the energy industry has fundamentally changed. There has been a regional supply picture shift, geopolitics, disappearing capital, stressed balance sheets—truly that perfect storm. It remains to be seen how all this will work out.

MIDSTREAM BUSINESS: What will bring the turnaround?

STICE: Mostly, a psychological acceptance that we can survive the health threats associated with COVID- 19 [and] once there is hope either through a vaccine or a reduction of positive cases, resulting in some containment of the virus. The market will be quick to embrace this hope and will begin to mend the substantial damage done to the market.

Market sentiment follows the psyche of the investor, which follows the psyche of the general public. When I was a trader, I would watch this oftentimes, and I would find myself surprised that, regardless of the fundamentals or the technical drivers in any one commodity, if the psychological impact is overwhelmingly negative (bearish) or overwhelmingly positive (bullish), then the market would operate irrationally for a period of time. That would occur until the bottom was defined or, in the case of a boom, the top was defined. That would mean that people had settled down and realized this was not the end of the world and that there would be life on the other side of a crisis event.

People are afraid of the unknown, so we can’t expect the markets to operate rationally until the psychology is recovered.

MIDSTREAM BUSINESS: Is the shale boom over?

STICE: The shale resource remains abundant, but the immediate boom is over. However, the shale supply will return once the math works again—and it will at some point.

Where does the industry go from here? The oil and gas industry must completely restructure its balance sheet to prepare for reinvestment opportunities that will result. The industry will experience a significant consolidation as a result of this shock.

“The energy industry has fundamentally changed. There has been a regional supply picture shift, geopolitics, disappearing capital, stressed balance sheets—truly that perfect storm. It remains to be seen how all this will work out.”

MIDSTREAM BUSINESS: The U.S. has emerged as a major exporter of crude oil, petroleum products and natural gas via LNG. How will that role change coming out of the present downturn?

STICE: I see the market continuing to need affordable and abundant fossil fuels long term, and the U.S. is well positioned to meet this demand. The fundamentals that people everywhere need energy have not changed. This current crisis will end, and we will be required to meet a growing, worldwide energy demand once again.

MIDSTREAM BUSINESS: Does the U.S. have a strategic advantage in comparison to other major energy exporters, and how can it exploit that advantage?

STICE: Well, if you think about three different levels of advantages or disadvantages, the U.S. is clearly advantaged when it comes to the abundance of commercially viable resources available.

First, we have a lot of oil and gas, and we have the technology it takes to commercially develop those reserves. It’s important to note that this strategic advantage is not going away. In fact, I anticipate that the technology will continue to improve. The second advantage is we have a currency and a political system that are viewed as stable. As a result, people want to partner with U.S. businesses as we tend to be a source of abundant and reliable supply.

Third—to our disadvantage—is the cost basis. If the cost of the incremental barrel is going to be defined by the difference between U.S. shale and Russia, they will beat us, and so will Saudi Arabia. So, to the extent that they want to exert pain on U.S. shale producers, they can. Their net production costs at the marginal barrel are much lower than our costs to produce an equivalent shale barrel.

However, I feel that both Russia and Saudi Arabia have incentives to maintain prices at a level that would allow them to pay their bills and grow their economies. At the end of the day, long term, there will be discipline by both Russia and Saudi Arabia to reach a reasonable price level that will allow all the players to play.

Now that means that if you’re the high-cost barrel in the U.S., if you’re sitting in a particular basin where you have no gas outlet or too much NGL content—too much ethane, for example, in North Dakota is one regional issue—you’re going to find yourself at a competitive disadvantage. I think the right answer to the question is, ‘It depends.’

I believe that over time we will find a price that allows for a healthy U.S. shale industry, a healthy production level from Russia and Saudi Arabia, and that number will be well north of where we are today. I don’t know if that number will be $40 [per barrel] or $55, or somewhere in between, but that feels like it’s about the right range. There will be some production that can’t compete at $40 here in the U.S., but there will be a lot that can compete at $55.

MIDSTREAM BUSINESS: What do producers need from midstream operators that they’re not getting?

STICE: Midstream operators appear to be delivering on the requirements of producers. The requirements are continuous delivery of existing production and revised configurations to adapt to the dislocated requirements by region.

I’m an engineer by training, and I was involved as a midstream operator, so I’d like to answer by outlining three steps. At the end of the day, the midstream sector has served both its upstream and downstream producers and consumers very well, and I think job one is to continue to do that. That is not a statement of the status quo.

First, there are multiple changes to the business right now. Among them are associated gas production going up; oil wells not necessarily producing as much or being deemphasized in this price environment, taking additional associated gas off the market; and the rise in additional dry gas on the market. All of this requires change to the configuration of gathering systems, the compressors and related equipment that it takes to get things done.

So in order for the midstream sector to deliver that same reliable service— safe, reliable service that they’ve been giving—the operators have to be out in the field making relatively major changes. So job one is to adapt to the new fundamentals and the new requirements that producers and consumers have demanded, given the changes in commodity prices.

Step two would be to go beyond these kinds of operations to ask where do we want to go with the market? Where do we go beyond compressor stations and operations? What can we do to help facilitate producers’ development needs? Producers are going to be a higher credit risk in this environment. Many of them are going to have balance sheets that can no longer afford to pay in a timely manner or, worse, to pay at all.

There’s going to have to be some cooperation between the upstream producer and the midstream operator to get through these difficult times. And midstream companies are going to be called on more than ever to provide services that might not necessarily be paid with the same timing, or contract terms, as in the past. They will have to be flexible enough to keep business rolling. And so that conversation is going to take place, and that’s more of a near-term issue, to shore up everybody’s balance sheet and make sure that we have the cash flow managed, doing favors to the extent you can to help people out and stay afloat. But it also means being disciplined enough to ensure that your own cash flow is not impaired.

That leads to the third step. I don’t think it’s all doom and gloom right now. I think that management teams can handle the first two things readily and successfully, and then the third thing will be to get ready for lots of opportunity for organic growth projects because of the reshaping of portfolios due to the commodity price impact.

Also, there will be consolidation in the industry. What’s happening now, I believe, will result in a large amount of consolidation. Frankly, some of that consolidation is quite needed, and some of it will result from unintended consequences—fallout of a perfect storm.

MIDSTREAM BUSINESS: Given recent capex cuts, what should midstream executives be doing now to ready their businesses for the future?

STICE: The opportunity to prepare for the future, again, includes three parts: business continuity [and] continued safe and reliable operations; management of cash flow to maintain healthy balance sheets and receiving revenue to pay bills in a timely manner; [and] then opportunistically evaluating targeted business development opportunities to consolidate operations and grow organically.

MIDSTREAM BUSINESS: Wall Street seems to have lost interest in all energy stocks, including midstream operators. Yet the midstream is a fundamentally different business than E&P. What can midstream executives do to differentiate the sector in the minds of investors?

STICE: Unfortunately, the midstream sector is an extension of the value chain from producers, and many producers are becoming a credit risk. Investors have lost faith in the entire value chain and will likely limit investment until the bottom is defined. Midstream executives can differentiate themselves by working with their producers and customers to offer customized solutions during this difficult time.

MIDSTREAM BUSINESS: What remains to be done in the midstream buildout, and will the capital be there?

STICE: Capital will be limited to high-return, organic-growth projects. Management will need to be creative in securing the capital needed to ensure the buildout continues.

MIDSTREAM BUSINESS: There hasn’t been a lot of talk about “the big crew change lately,” given that the industry is once again in the throes of staff cuts. You’re in education now, so what should the industry be doing to encourage a new generation to enter the business?

STICE: It’s a difficult issue right now, but clearly something that needs to be addressed. This fall, new students will choose careers once again.

As the dean of OU’s College of Earth and Energy, I have seniors that are graduating with petroleum geology degrees and petroleum engineering degrees, and the prospects are pretty bleak. I mean, what will they have to do for a while? Now, that is not a unique question. We’ve had this occur five or six times before just during my career. In the past, it has always been relatively short-term, maybe 12 to 24 months.

However, we were already in a downturn prior to these new challenges, so I think that the period of time that a new graduate might have to pursue something different before finding a meaningful role in his or her degreed profession could be longer. I don’t know if that’s two years or three years, but it could be even longer.

I would not be discouraged if I were a freshman right now. But if I were a junior or senior, this is going to be a tough time to find a job, especially a meaningful job in your area of expertise, something that you want to do right away.