Low demand leads to shrinking energy industry valuations

By Ellen Chang

The energy industry faced a brighter potential at the start of 2020, but the Russia-Saudi price war on the industry triggered a breakdown in OPEC talks, and an oversupply of oil and low demand brought on by COVID-19 led to enormous changes for companies throughout the sector, experts said at a session titled "The Impact of COVID-19 on Energy Valuations" at the AICPA/PDI Oil & Gas Online Conference last week.

The industry has rebounded from its lows this past spring when oil prices plummeted as massive shutdowns curtailed demand, air travel ground to a halt, and many businesses switched to remote work, lowering demand. Currently, all sectors remain weak due to prolonged global demand setbacks and oversupply.

While both oil prices and energy stocks have rebounded from their lows in March, crude oil at $40 a barrel is not sustainable for the industry even though technological changes have improved efficiency and margins drastically, Seenu Akunuri, a principal and leader for PwC's U.S. energy and mining valuation practice in Houston, said in the Nov. 18 conference session.

"There is not much demand from consumers," Akunuri said. "We can't really see light at the end of the tunnel until there is clearer guidance on when the [coronavirus] vaccine will be available to the market."

The impact of the coronavirus pandemic pushed many companies to merge, creating several billion-dollar deals: Concho Resources was acquired by ConocoPhillips for $9.7 billion, Parsley Energy was purchased by Pioneer Natural Resources for $4.5 billion, and Chevron bought Noble Energy for $13 billion.

Low oil prices and demand also resulted in many overleveraged companies in distress to file for Chapter 11 bankruptcy this year. Law firm Haynes and Boone reported that 40 onshore oil and gas companies filed for bankruptcy through Sept. 30, totaling more than $50 billion in debt. This amount of bankruptcies is lower than in 2016, when 70 companies filed for bankruptcy in the wake of a plummet in oil prices as a result of U.S. shale oil flooding the market. Many oil and gas companies were already in trouble when the pandemic hit in March because they were overleveraged, and several of them took "significant" write-downs in both the first and second quarters, Akunuri said.

Every single sector within the energy industry has faced immense setbacks in 2020, including upstream, midstream, downstream, and oilfield services, said James Jordon, a managing director and a member of BKD's forensics and valuation services division.

The key question now is how much oil and gas will be needed when demand returns, since companies have found ways to work efficiently remotely and fewer miles are being driven overall, he said during the conference session.

Over the past two years, the refining sector performed better than other sectors in the industry and was a "brighter star" because of higher oil prices, Jordon said. This year was originally estimated to be a "good year" for the sector, he added, based on crack spreads as of December 2019 and the new marine shipping fuel standard becoming effective in 2020.

The midstream sector, which consists of pipelines and gathering systems and has always produced a steady cash flow and "dividend-like quality to distributions," Jordon said, was also affected in 2020. Midstream companies faced "a lot of disruption" due to legal and political challenges and now face a higher cost of capital for financing projects, he said. These companies are also dealing with customers renegotiating contracts, which increases pressure on operations and how buyers evaluate midstream assets.

The debt on the balance sheets of some midstream companies indicates that many are facing distress and the sector is likely to see some consolidation to lower costs, make assets more efficient, and better connect supply to demand, he said.

During a period of low returns to upstream equity investors, companies and management are facing risk aversion in investors, and it has driven them to seek investments that can generate stable production with free cash flow, said Steve Hendrickson, president of Ralph E. Davis Associates.

"There is increased scrutiny on undeveloped resources from investors," he said at the conference.

Engineers have also sought ways to increase hydrocarbon recovery, reduce costs, and generate the best economic returns in the development of unconventional resources in the industry, Hendrickson said.

He pointed to the Permian Basin in West Texas and eastern New Mexico, calling it "one of the most active plays in the U.S.," with attractive break-even prices and rig count that has increased in the past few months.

Another challenge facing energy companies is the basis differential. Its volatility can result in meaningful uncertainties in valuations, Hendrickson said, and is a source of risk that can't always be hedged effectively. Some of the sources of basis volatility are low demand pushing down prices for products that are far from the markets and excess local supply overrunning infrastructure. Drilling reductions in some basins are causing basis differentials to improve as demand on infrastructure is reduced.

As 2020 closes, the energy industry faces many headwinds, and estimating when oil prices will make a comeback remains challenging while demand remains low.

For information on the AICPA's Accredited in Business Valuation (ABV) and Certified in Entity and Intangible Valuations (CEIV) credentials, visit the AICPA's website.

Ellen Chang is a freelance writer in Houston. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, (Kenneth.Tysiac@aicpa-cima.com), the JofA's editorial director.

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