HOUSTON—The oil and gas industry, now in what is considered the longest downturn in its history, has lately shown signs of optimism.

Globally, capex is up 7% and in North America upstream spending is expected to climb 23% compared with 2016. Yet John England, Deloitte LLP’s vice chairman and U.S. energy and resources leader, calls the recovery “the slow road back.”

“The recovery we’re going to have is going to happen,” England said at the Mergermarket Energy Forum on April 20.

But the slow road carries the potential for rough patches, unfinished stretches and perhaps even sinkholes. Increased spending, hedging, greater than expected production and the continued suffering in the oilfield service sector are all catalysts for the recovery—and potential pitfalls.

With the industry’s ramp-up for a rapid restart, U.S. supplies and record oil inventories will likely lead to increased exports. That could complicate the globe’s complex rebalancing equation for oil supply and demand.

In January, U.S. oil exports reached new heights with 750,000 barrels per day (Mbbl/d). The uptick comes despite Deloitte assumptions that lost manpower and mothballed equipment would provide guardrails for E&P production.

A crucial variable remains for OPEC—and Saudi Arabia in particular. After the organization agreed to scale back production for six months, prices started to recover as an unexpectedly compliant OPEC withdrew 1.5 MMbbl/d from the market.

In May, OPEC will decide whether the quota will stay, go or change.

“What is OPEC going to do? What is the OPEC response to [the] U.S. shale production increase going to be? That’s one of the most fundamental questions,” England said.

But it will be faced with a decision of possibly ceding market share to the U.S. Saudi Aramco’s desire to IPO is viewed as playing a major role, since the company will want to go public when prices are as high as possible.

“There are signs that will extend through the end of the calendar year,” England said. “But we don’t know that.”

The Loop

Uncertainty has led E&Ps to protect against the risk of falling prices by hedging production for 2017 and 2018, with prices at $50 or more.

“There’s been a real rush to go ahead and hedge up production going forward. And that’s going to lay the ground for what drilling programs are going to be put in place,” England said.

England has been a proponent for hedges, but a contrary view has emerged regarding how they affect the market.

Hedging, the thinking goes, has actually contributed to the festering of the downturn.

“Really, what it does is it incentives you to keep drilling and keep producing because you can lock in good enough economics to make it work. To some degree it’s taken out our typical boom and bust cycles a little bit and smoothing some of that,” England said. “You might say that’s good. But it also means there’s going to be continuing U.S. production flooding into the market, which is going to put downward pressure on prices.”

“So to some degree it makes it more difficult to ever break out of this kind of price loop that we’re in,” he said.

England said hedging makes sense to him, but he does see it furthering or at least prolonging the downturn.

However, locked-in pricing and low breakevens enable M&A.

“The lowest breakevens and favorable hedges helped enable M&A in the Permian Basin, especially in the second half of 2016,” England said.

A Little Short?

Since the downturn began in 2014, a great deal of capital has been pulled out of the industry. Lenders have been particularly stingy as the value of reserves plummeted.

The industry runs the risk of a serious shortage of capital flowing into the industry, and the long-term impact could be devastating.

“And this isn’t just any old downturn. This is the longest downturn we’ve ever had in this industry. When people say they’ve seen this before, you haven’t seen this before. It’s important to understand this,” he said.

The oil and gas industry requires enormous sums just to maintain reserves and production. That raises the question of future supply shortages down the road.

While England expected some companies to repair their balance sheets as prices improved, they’re instead spending more on capex.

Companies that are “already levered up” are spending more on capex year-over-year.

E&Ps that had invested long-term capital into projects such as deepwater drilling were burned during the downturn.

“I think there’s a lot of this scar tissue that’s going to be with companies going forward,” England said.

The emerging view is that tying up capital for too long is too risky and shorter-cycle investments are the wiser course.

“You see a real push toward more capital flexible projects … so that sends lots of money to U.S. unconventional projects,” he said.

But that mentality raises the question of whether shale production can pick up the slack from megaprojects that are being bypassed.

“Are we going to need the big deepwater projects, are we going to need the big LNG projects? I tend to think we still will,” he said.

Robots’ Play

The question—how much of reduced breakeven costs were built on innovation and how much on the back of service companies—is one that simply will not go away.

Lower oilfield service costs and an improvement in lateral adjusted per-well recoveries have reduced breakevens across the shale plays. On average, 2016 breakevens were 35% to 40% lower than 2014.

But oilfield service companies remain stuck 25% below 2014 prices.

Globally, oilfield services spending declined 28% in 2015 and a further 34% in 2016, according to Argus Energy Managers. Spending is expected to rebound by about 17% in 2017, according to Argus Energy.

Charles Cherington, co-founder of Argus Energy, said at Hart Energy’s recent Executive Capital Conference in Austin, Texas, that the sector remains in damaging financial straits.

Other than sand and selective coiled tubing experiencing price inflation, oilfield services are “hemorrhaging less, as opposed to making any money.”

England said that, anecdotally, services companies have told him they are in deep trouble.

“How long, and how much are we going to continue to produce before that price inflation, the equipment inflation starts really creeping back in in a bigger way and starts bringing up those breakevens?”

England said technology, including robotics, could offset some of the inflation that’s certain to come. Some of his clients are already using digital technologies to save costs but, overall, the industry remains digitally primitive.

However, U.S. producers have already shown how adaptable they can be.

“The U.S. is really good at innovating and really good at becoming first movers on technology,” he said. “That creates an advantage. We’re going to get to these changes quicker and that’s going to really advance our industry going forward.”

Darren Barbee can be reached at dbarbee@hartenergy.com.

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