The Barrel: Down, but not out

Colin Welsh, CEO of Simmons & Co. International Ltd.

January 1, 2016

From an oil industry perspective it's difficult to find anything positive to say about 2015 other than I'm glad it's come to an end.

Colin Welsh. Image courtesy of Simmons & Co.

I certainly didn't see $35 Brent crude coming, nor did I envisage such low prices looking like they will endure through 2016. The impact on oil service companies has been brutal with most being hit with revenue declines in the 30% to 50% range devastating bottom line profitability and resulting in tens of thousands of employees losing their jobs.

The impact on M&A in 2015 was profound because it's impossible to conclude a deal when profits are declining month on month and neither the buyer nor the seller has any clue when that will stop.

The best companies cut costs hard early in 2015 and cut again and again in an attempt to bolster the bottom line. Those slower to react have paid a heavy price in terms of profitability, particularly those with high levels of debt.

The full force of the downdraft will be felt in 2016 as bank covenants are breached and equity values are compressed or obliterated. History tells us that this is a time when banks pass problem children on to specialist lending groups whose sole motivation is to recover as much of the bank debt as possible. At best this results in companies having to spend much more time on internal matters and less on winning new business. This makes it even tougher for the company to recover. At worst the company goes into a death spiral as the banks and private equity firms spend weeks/months fighting each other. This usually results in insolvency as it's very difficult for private equity firms to put more money behind a company that it recently invested in when the original investment has been lost, and specialist lending teams don't have the patience or sector knowledge to take the long term view that is necessary.

 

The mantra for oil service companies in 2016 has to be to do everything possible to stay in business. To achieve that, they need to become as efficient as possible. That isn't just about paying off staff, it's about rethinking business processes and strategies. E&P companies are more open than ever before to new ideas and different ways of doing things if it means that they can reduce costs.

This is also a time to consider combining businesses in order to remove overhead, enhance capability and build scale so that the business becomes more robust and can withstand a lower for longer downturn. The time to explore merger possibilities is definitely before a bank covenant is breached because once the bank specialist lending teams get involved the decisions pass out of the hands of the business owner. We are very keen to see the number of business failures minimized and consequently, irrespective of the size of the business, are encouraging companies to have an open discussion with us to, if nothing else, identify the financing and merger options that that are available to them.

As a glass half full person, I'd like to end this rather downbeat piece with a couple of positive observations. The first is that the longer term outlook for the oil industry isn't as bleak as most people are forecasting. The oil price will recover, but it will take time. When it does those companies that have navigated the downturn to their advantage will be spectacularly well placed. The restructuring that is required in 2016 must be seen in the context of being in preparation for that, and therefore as an opportunity. As Warren Buffet said "Some things just take time. You can't make a baby in a month by getting nine girls pregnant!"

My other observation is that we might see a surprise uptick in crude prices in the back half of 2016 as production declines move into focus. In that regard, at the time of writing, I see that the EIA is predicting that production from the seven key shale areas in the United States will fall by 4.3% over December 2015 and January 2016. Assuming accelerating declines, this could result in an annual decline of around 25% or more over 2016.

In a similar vein, given the extent to which the brakes have been put on drilling activity you have to expect that production declines from conventional wells globally will be much higher than usual. Dial in the potential for the Middle East powder keg to impact production there and anything is possible.

Colin Welsh joined Simmons & Co.
in 1999 to establish the firm’s Eastern Hemisphere business. Prior to joining Simmons, in 1987, Welsh established the Aberdeen office of RMD, a newly formed accountancy and corporate finance firm. Previously, he worked in both the London and Aberdeen offices of Touche Ross. Welsh graduated from Aberdeen University having studied econom-
ics, accountancy and law. He went
on to qualify as a Scottish Chartered Accountant while working at Ernst & Whinney (now Ernst & Young).