Introduction
Long before the fabled price war and subsequent global pandemic, the domestic oil and gas industry as a whole was struggling. Hundreds of billions of dollars in debt was forcing hundreds of U.S. based oil and gas companies down the path towards bankruptcy in the five years before oil prices went negative for the first time in history. When the United States Government intervened in an attempt to save the industry, many argued it was too little too late. But the fact of the matter is, the industry as a whole was struggling and on the brink of disaster long before prices annihilated many companies’ bottom line. Frankly, the money injected into the oil and gas market is simply delaying the inevitable because most companies were not making money – even when times were good and prices were high.
Struggles Before COVID-19
When global stock markets began to crash in late February after reaching record highs, it sent financial markets into a tailspin. In early March, global markets became extremely volatile with large swings occurring worldwide. During this time the United States Congress authorized the Federal Reserve to inject 2.3 trillion dollars into these struggling financial markets [4]. When such actions were taken, it included the capacity to lend directly to individual sectors and companies in the real economy, along with indirect purchasing of bonds to specific sectors [1]. In other words, the Fed was authorized to buy billions of dollars in corporate bonds in the energy industry, in addition to direct lending to companies themselves.
Many climate activists, environmentalists, and individuals or groups opposed to the oil and gas industry were outraged by the move. Even others argued that the money should have been used to support workers facing prolonged unemployment and other economic hardships [7]. While many times anti-oil claims are stubborn and based on pure stigma against the industry, they may have a point here. The Federal Government might just be propping up an industry that was struggling long before the market downturn. This is made evident by investigating market trends in the five years leading up to the 2020 stock market crash and simultaneous price war.
Struggles Before COVID-19 – Falling Prices
July 30, 2014 was the last time oil was above $100 per barrel. From there, prices fell until they settled in the $50 range from January through July of 2015. The drop from $100 to $50 oil forced many companies to re-evaluate spending habits and focus on maximizing the lifespan of their wells instead of drilling and completing as many wells as they could to pull as much oil out of the ground as possible. It forced them to adapt and to make smarter decisions. When oil fell below the next threshold, $40 per barrel, through December 2015, more had to be done than simply tightening the belt. Lifting costs had to be driven to new lows to ensure profitability at low oil prices, especially when prices entered the low-$30 range. This was when panic began to set in as companies were poised to be profitable at $40-$50 oil but no lower. It was also when the first wave of bankruptcies began to roll in. Although the price of WTI returned to the $40’s in April of 2016 and slowly climbed for nearly three years, so did the bankruptcies.
Struggles Before COVID-19 – Bankruptcies
Since the shale revolution in 2008, there has been limited technological advances in the oil and gas industry. High prices did not warrant the need for technological progress to drive efficiency. The focus was drilling and completing wells at a breakneck pace to bring on as much oil and cash flow to the table as quickly as possible. The sharp drop to low prices created a need to adapt for survival. Unfortunately, some were unable to adapt as seen by the large jump in bankruptcies during Q2 of 2016 and an overwhelming 200 North American oil and gas companies declaring bankruptcy since 2015 [1]. Figure 2 shows the constant climb in bankruptcies every quarter in the E&P sector. A major problem to this trend was oil prices steadily climbed from Q1 2016 through Q4 of 2018, but the bankruptcies kept rolling in. Even after a minor decrease from Q4 2018 into Q1 2019, commodity prices were still above 2015 levels – a price region domestic operators had plenty of time to adjust to.
Struggles Before COVID-19 – Debt
So what was the issue? The short answer: corporate debt. United States E&P companies were simply taking on more and more debt to stay afloat. They became overleveraged and lost focus of their bottom line. There was a huge spike in aggregate debt during Q2 2016, which paired with a huge spike in bankruptcies, but both secured and unsecured debt for US oil companies has been growing exponentially since 2018. Unsecured debt, or debt that has no collateral backing, allows lenders to issue funds with an unsecured loan based solely on the borrower’s creditworthiness and promise to repay. Figure 3 shows the level of this debt was much higher than its secure counterpart [4]. Since domestic E&P companies did not need to put up any assets as collateral on their loans, there was low incentive to quickly pay them back. As a result, companies only used cash flow to make interest payments on the debt instead of reducing the principal balance. The companies were getting stuck on a hamster wheel since the interest never decreased. As cash flow began to restrict with lower prices and maturity dates grew closer, the debt began to pile up, bringing with it crashing credit ratings.
Of the 158 sub-industries defined by the Global Industry Classification Standards (GISC), “oil and gas drilling” saw the worst decline in credit ratings over the last five years (through the end of 2019, before the onset of the pandemic) plunging by 44%, according to their report [3]. The bottom line is: in the 15 years since the first U.S. shale boom, the industry as a whole has failed to return a profit. The result has forced the current average credit rating for E&P companies equivalent to an S&P “B” rating putting the sector in non-investment grade or junk territory [6]. With such poor ratings, why would the federal government invest in these companies when companies in other sectors performed much better? Healthcare companies saw an average decline in credit quality by only 6%, communications improved by 4%, and real estate grew by 3% over the period when oil and gas fell by 44% [4]. These historic trends tend to strengthen the opposition’s argument of the actions taken by the US government, but that is just one factor.
Federal Actions Taken
Regardless of a troubled past, the government stepped in to help save the struggling industry. The Federal Reserve made an initial purchase of $1.3 billion in corporate bonds at the end of May and roughly 8% percent of that went to oil and gas [1]. While the sector only represents 3% of the S&P 1500 it was hit a bit harder during the economic recession than many other industries due to the dual black swan events of the coronavirus and oil price war. Of the $100 million that went to oil and gas, a fifth of that went to companies with credit ratings in junk territory [1]. The intentions were genuine and thoughts were clear: the government stepped in to save an industry that fuels this country. Unfortunately, the timing and execution of these actions was not perfectly carried out.
Additionally, the Federal Government opened new lands for leasing opportunities, eased some environmental restrictions, and the Bureau of Land Management temporarily cut companies’ royalty rates on federal lands. All these actions promoted the wellbeing and longevity of the industry, but it was met with harsh criticism. On one hand, opening new lands for oil and gas opportunities allows companies to expand and explore new areas, but on the other hand many of these lands were closed for a reason. The easement of some environmental restrictions makes operating many leases significantly cheaper which greatly assists economics in a low price environment. It also allows for the potential of an environmental incident to be much higher. While these actions by the government had good intentions to save a fundamental industry supporting the domestic economy, the execution could have been improved.
Conclusion
While it is perfectly reasonable for the government to step in and help an industry struggling during the current downturn, some of the actions taken were questionable. Because the energy sector has been on a declining trend and struggling for years, it is much harder to justify intervention based on logic that this is a temporary setback related to the coronavirus, as is the case for other sectors.
Other actions taken to open new lands for leasing were more in line with assistance that could propel the industry to new heights. The possibilities of developing a new area previously restricted opens the door to new opportunities, jobs, and technological advancements. Unfortunately, some of the actions taken may end up hurting more than helping in the long run. For instance, the Bureau of Land Management cutting royalty rates in a state like Utah will nearly dry up much needed revenue streams for local governments. While the move is assisting one industry, it indirectly harms several others.
Opposition to actions taken to save the oil and gas industry have been growing in the past few months with many citing “the extraordinary intervention represents support for parts of the economy which may have been in secular decline prior to the pandemic. If this is the case, it raises questions surrounding moral hazard and distortion of free markets as well as the taking on of excessive risk by the Federal Reserve on behalf of US taxpayers” [7]. The issue is, these individuals are not looking at the bigger picture. America’s oil and natural gas industry supports 10.3 million jobs in the United States and nearly 8% of our nation’s Gross Domestic Product [9]. Not only is it an industry responsible for tens of millions of jobs and a huge portion of GDP, it was an industry predicted to be one of the hardest hit by the global pandemic by the Brookings Institution. (Note: Mining includes the oil and gas industry).
These predictions were published in mid March just one month before the unemployment rate in the United States rose to a record 14.4%, the same time when oilfield service jobs fell a similar 13.5% year over year [11]. Luckily for many parts of the economy, things are starting to pick back up. With elongated depressed prices in the oil and gas industry, little gains have been made to recover these job losses.
The oil and gas industry is essential to fuel the economy and push society to new heights. Our modern society was built from oil and gas, and without assistance during the current downturn a key pillar supporting the United States economy would have failed. While the execution was not perfect, it is understandable. Without all of the data available it can be difficult to always make the best decision, but the government waiting for additional information could have caused further economic damage. Actions were taken to ensure the survival of the industry that fuels the progress of modern society. The next step will be for domestic oil and gas companies to re-evaluate their business model with an emphasis on cash flow. This will ensure the success of organizations at lower commodity prices without the need for further government assistance when times get tough. Oil and gas is an industry built on resilience. Companies can easily benefit when prices are high, but must be prepared to adjust to be successful when prices are low.
References
[1] https://oilprice.com/Energy/Energy-General/How-The-Fed-Bailed-Out-US-Oil-And-Gas.html
[2] https://oilprice.com/Energy/Energy-General/US-Shale-Has-Lost-300-Billion-In-15-Years.html
[4] https://www.federalreserve.gov/publications/reports-to-congress-in-response-to-covid-19.htm
[5] https://www.haynesboone.com/publications/energy-bankruptcy-monitors-and-surveys
[6] https://www.drillednews.com/post/the-climate-covid-19-policy-tracker
[8] https://www.nrdc.org/experts/josh-axelrod/oil-and-gas-bailout-gusher