The oil and gas sector has been dealt a double blow. Crude oil prices were in decline earlier this year with the price of WTI (West Texas Intermediate) falling by 20% in the month from 6 January 2020. This was then followed by a massive drop caused by a rapid fall in demand as a result of COVID-19. The demand has not recovered and oil prices continue to be suppressed, although they have recovered from the lows of April 2020.
Unsurprisingly, this perfect storm has had a deep impact. Discretionary spend is down as International Oil Companies (“IOCs”) and National Oil Companies (“NOCs”) aim to conserve capital and reassure shareholders of their ability to survive the crisis. New projects are being put on hold and, by some estimates, global investment in exploration and production will fall by $100 billion in 2020 or 17% below 2019. Oil majors are introducing spending cuts of around 20% on average in the existing supply chains. Can the supply chains, where margins are often low, survive these cuts? A recent white paper by Kearney (see here) reveals that highly leveraged suppliers with a short backlog of contracts are the most exposed, as evidenced by the recent Chapter 11 filings of offshore drilling contractors like Diamond Drilling, Noble and Valaris. Whether and how suppliers will survive remains to be seen, but some clues can be gathered with the benefit of experience gained from the 2014 oil price crash.
The current crisis is not entirely dissimilar to the 2014 crash. As then, the service sector is now finding itself as the first port of call for savings. In the period 2014 – 2019, the industry witnessed a 55% reduction in unit development costs, with half the cuts coming from the supply chain. As then, the present cuts are both to expenditure (operational and capital) and to the scope of activities performed by the supply chain. But there are some material differences. The supply chain is already weak from the impact of the 2014 crisis. The pressures faced now are exacerbated by logistical difficulties in the movement of labour and equipment, and complications with manufacturing caused by COVID-19, and also high interest rates. Aggressive price cuts could lead to widespread supply chain distress, much wider than the sporadic supplier insolvencies that operators are accustomed to.
The market is therefore gradually realising that traditional cost saving measures are not good for the overall health of the sector and, in some ways, the reaction to the crisis is different to that in 2014. First, operators are starting to take more interest in the financial health of their supply chain and specifically business critical supplies. They are looking past standard financial metrics and relying on specialist expertise to monitor supplier health. Metrics such as the past performance of suppliers in the face of price cuts and competition analyses in different supplier categories are being evaluated. Operators and suppliers are also having more open conversations. Second, operators are finding new measures to alleviate supplier distress: (i) making payments ahead or on time; (ii) extending lines of credit; (iii) liaising with other operators to bailout supply chain players; (iv) resolving production issues through raw material supply agreements; (v) lobbying for exemptions and support packages and assisting with logistical issues relating to border controls. Third, and while there will always be competitive tensions, a focus on supplier relationships and strategic alliancing is now coming to the fore. In strategic alliance arrangements, the focus shifts from price to value – the quality of the service provided drives the price. Operators are evaluating long-term strategic partnerships with key suppliers to ensure consistency in supply and lower costs in the long run. While this may need some support from governments in terms of easing competition requirements, it is certainly a step forward in creating more stable supply chains.
Of course, there are still expenditure cuts and their impact on existing operator-supplier contracts is unavoidable. Where any items of work are de-scoped by the operator, there may be significant scope for dispute on how the new price for the work is to be determined and a fair valuation may need to be agreed – or determined by a third party. A major de-scoping can undermine the viability of the whole contract with a supplier unable to cover fixed costs without a sufficient balance of work remaining. In contracts where the supplier bears a material portion of the risk, and has priced that risk in rates for the work as a whole, a significant reduction in work is not necessarily met by a commensurate reduction in risk. The supplier is thus exposed, and the potential for disputes and for disruption to the supply chain is obvious. Alliancing and strategic contracting are, as stated above, more focused now on value-based pricing and may offer a better way forward than the traditional model.
Interestingly, environmental, social and governance (“ESG”) goals have been less affected by the crisis. Recently, there has been a huge momentum driven by regulatory and shareholder pressures for operators to adapt their businesses to ESG considerations – e.g., Total SA’s shareholders recently called upon the company to further reduce its carbon emissions; in August, BP announced a 10 fold increase by 2030 in low carbon. This momentum is unlikely to be lost and there is, in fact, a renewed focus on ESG. Operators are conscious that investors value the scores assigned to their businesses by ESG rating agencies, and that this is unaffected by COVID-19 or oil pricing. They will therefore have to remain mindful that their supply chain must meet their internal ESG criteria, even if there are urgent replacements owing to insolvencies or terminations.
The industry is in considerable flux, not just in recovering from the recent price and demand shock, but also navigating a sustainable energy transition. A resilient supply chain is essential for long-term stability. The market is consolidating but not to a simple scenario of fewer players in the same game. It is embracing new contracting models, with strategic alliancing at the fore. Only time will tell if that is a long term shift; but it has all the signs that it will be.
The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2020