Editor’s Note: This is one of a 14-piece series NGI undertook as the energy industry readied for the new year, with Lower 48 natural gas and oil supply continuing to surge in an uncertain environment as liquefied natural gas exports ramp up, Mexico markets remain shrouded and stakeholders demand more value. Get your complimentary copy of NGI’s 2020 Special Report today.  

The natural gas and oil sector is coming to grips with a bevy of uncertainties this year, as capital markets are drying up, investors are fleeing and the global community voices increasing concerns about fossil fuels.

Energy industry prognosticators see a foggy 2020, potentially a repeat of sorts from 2019, with a mild increase in capital expenditures (capex) for the exploration and production (E&P) sector and continued pain for oilfield services (OFS).

The Evercore ISI analyst team led by James West recently compiled the 2020 Global E&P Spending Outlook, an annual sampling in which data was collected from more than 250 oil and gas operators of all stripes --  publics, privates, domestic and internationally focused, from the smallest of the moms-and-pops to the supermajors.

The “tale of two markets” is arriving this year, West said. The pain in North America (NAM) “is being felt all around,” with more than 32 bankruptcy filings by North American E&Ps last year amounting to around $13 billion in debt.

Investors also are exiting the sector. A dollar invested in the OSX Index 20 years ago would have fetched “an extra penny in your pocket, compared to nearly $5 for the S&P 500,” West said. “This clear disconnect has brought energy weightings in the S&P 500 to between 4-5% versus a stunning 15% this past decade.”

NAM operators are in search of a new normal, as the pullback in drilling and completion activity started earlier last year than in 2018, and the decline in the rig count was steeper than most operators had expected, the survey indicated.

After increasing by 46% in 2017 and 20% in 2018, NAM capex is set to decline for two consecutive years, with 2019 and 2020 both expected to be down 6%, respondents said.

North American Muddle

“The NAM market is best described as a muddle in 2020, driven by the continued backdrop of lower for longer spending and activity levels by operators,” West said. Consolidation also has had an impact.

A pickup in activity levels in NAM is expected as new budgets are reset, “but visibility is poor and management teams are uncertain. ”

E&Ps also have sobered up about price assumptions. When the survey was conducted late last year, respondents were expecting 2020 crude to average $53.75/bbl West Texas Intermediate and $58/bbl Brent. Recently, with increased instability in Iran and Iraq, oil prices have been moving higher.

The latest survey still “denotes a marked shift in thinking versus prior years, and we believe that a relative lack of funding is also another driving factor as the upstream learns to sustain itself on internal cash flows,” West said.

Nearly one-quarter (27%) of those surveyed said they would not increase capex, “no matter how much pricing increases, which we found to be noteworthy.” One-half said they would “neither increase nor decrease their capex plans under any price scenario.”

The E&P executives also are harboring a more bearish view on natural gas compared with 2019. For 2020, the average price deck forecast for natural gas is $2.37/Mcf, which is 6.9% below Evercore’s 2020 estimate.

By comparison, Goldman Sachs is expecting Henry Hub to average $2.20/Mcf this year, with an average price of $2.50 in 2021, and $2.75 in 2022 and 2023. The U.S. Energy Information Administration expects Henry Hub to average $2.45/MMBtu in 2020, down 14 cents from the 2019 average.

RBN Energy LLC President Rusty Braziel, in the eighth year of posting prognostications, said the shale/tight resource era has not ended, “but it is going to be much more difficult to get projects done.”

Last year saw a few “profound market shifts that will be with us into 2020 and beyond,” he said.

For one thing, “Wall Street has soured on anything to do with oil and gas, and that’s tightened capital markets for both drilling and infrastructure. But it is deeper than that.”

The energy industry is “shell-shocked from what seems like a continuous cycle of capacity constraints, the need for long-term capacity commitments, overbuilds, low prices and collapsing price differentials.”

The entire infrastructure development process also has slowed, and E&Ps “are more inclined to deal with capacity issues in a few years rather than sign up for a new project today. That’s the reality of the shale era as we enter the new decade,” Braziel said.

Morningstar Commodities Research’s Sandy Fielden, who directs oil and products research, said “a sense of shale fatigue lingers in the air at the start of 2020, with drilling slowing and a challenging investment environment for producers.”

As Lower 48 oil output continues to grow, the Organization of the Petroleum Exporting Countries (OPEC) and allies have protected prices by reducing their production. However, “the threat of excess supply has pushed forward markets into a contango structure with December 2021 futures settling $8/bbl below the prompt contract,” Fielden said. “That leaves U.S. producers and the crude market vulnerable to slower economic growth.”

Rig Count Bottom

Raymond James & Associates Inc.’s analyst team led by Praveen Narra said strip prices suggest the U.S. rig count likely has bottomed.

The final quarter of 2019 marks the trough for rig activity, with the U.S. count “up 6.1% from here and fracture demand up 8.1%,” Narra said.

“Our strip rig count...is based on a bottoms-up, basin-by-basin approach, which forecasts which companies will be running rigs and where. This forecast considers announced capital plans, public E&P budgets, oil and gas breakevens in major plays, as well as the current futures strip prices.

“Overall, we currently estimate the total U.S. rig count will average 910 in 2020, a decrease from the 2019 average of 945.” The 2020 average horizontal rig count forecast calls for a 45-rig increase in the next 12 months, with 30 rigs destined for the Permian Basin, or 66% share of incremental rigs.

Hedges, Anyone?

Capital discipline is “easy for producers to talk about” when West Texas Intermediate (WTI) is trading at $50-55/bbl, “but a lot harder for investors to believe at $60-plus,” Tudor, Pickering, Holt & Co. (TPH) analysts said.

“One of the dominant themes of our client conversations following the Iran news late last week was the potential for added activity and hedges given a higher 2020 curve, which now stands at $61 WTI. Early feedback from coverage companies appears to be in line with our thoughts that cash flow uplifts will flow to balance sheet repair/increased shareholder returns rather than incremental production growth.”

From a hedging standpoint, producers are expected to lock in solid prices for 2020 and 2021.

With earnings season set to begin later this month, “it’s imperative that companies stand firm to this message on 4Q2019 conference calls when the majority of 2020 plans are revealed as capital discipline remains a prerequisite for long-term money to return to the space.”

The TPH team also reflected on the past decade. At the end of 2009, the U.S. rig count was on its way to 2,000-plus, while the Haynesville Shale was the second most active U.S. play after the Permian.

“Part of the beauty of embarking upon a new decade is knowing that there will be geopolitical and industry events and technological innovations which are (today) predictably unpredictable, but which will notably influence global supply/demand balances across the energy value chain,” the TPH team said.

“With North American E&P operators still relatively new, and thus enthusiastic, converts to the religion of capital discipline and value over (production) volume, and with the (short-term) threat of a sub-$50/bbl WTI oil price increasingly in the rearview mirror, we like the backdrop for generalist investors to find their way back to our energy industry as the new year unfolds.”

The building blocks were set last year as E&Ps improved costs and reduced spending.

“Our positioning in 2019 was to avoid gas and stay overweight large cap oil versus smaller peers, and going into 2020 we’re not quite ready to shift that message -- at least through the first half of the coming year,” the TPH team said. “To sum it up, while we wait for an improved gas macro outlook, we’re betting that capital inflows hit the larger-cap oily names first…”

Cash Flow Squeeze

Low commodity prices may limit opportunities for E&Ps to build cash flow this year too, according to Moody’s Investors Service. The OFS sector in turn then could see revenue and cash flow shrink as customers retreat, said senior credit officer Amol Joshi. “Tepid” activity in turn also may upend midstream opportunities.

Because energy operators have to attract equity investors, “many are returning excess cash flow to shareholders rather than reinvesting in their businesses to grow at any cost. But equity investor returns have yet to improve” since oil prices crashed in late 2014, Joshi said.

Investor sentiment has soured even more since mid-2019 on continued U.S. supply growth, the risk of renewed economic uncertainty and tariff wars.

Meanwhile, environmental, social and governance (ESG) goals are becoming de rigueur, as operators acquiesce to investors by pledging to reduce carbon emissions and improve the places where they work.

Instituting ESG goals is a must, Joshi said, as “capital providers with environmental or social directives are also actively reducing their exposures to energy companies, limiting the capital available for such companies.”