A Perfect Storm: COVID-19 Pandemic Doubles the Challenge for Energy Factors
The oil and gas industry was having a difficult time before COVID-19 created even more uncertainty. With the combined negative effects of a global pandemic and a pricing war, the energy sector is facing a bleak future and that will make life difficult for factors focused in this area. Mark Zitzewitz of TCI Business Capital looks at the current downturn and outlines three important steps factors must take to ensure they survive.
BY MARK ZITZEWITZ
Dan Dicker, noted author and commentator on the oil and gas industry, once wrote, “Oil is a lousy investment because it isn’t an investment. It’s just a bet — and it’s a bet with a ticking time bomb attached to it.”
Factors, and the service companies they finance in the oil and gas sector, heard a deafening boom this spring and have been busy ducking the shrapnel of an exploded industry. A historic plunge in oil prices coincided almost precisely with the worldwide coronavirus pandemic, and the combined impact has both near and far-term effects on factoring companies in the energy sector. Those that have weathered these events before, in this or other industries, need to fall back on the best practices — not just bets — that have allowed them to survive the storms and grow in sustainable ways on the other side.
TWO CRISES
The initial crash of the oil industry preceded the coronavirus crisis in America. Throughout 2019, oil prices remained relatively steady, with forecasts of significant growth for the industry. But in late February, Saudi Arabia announced it would not curtail production, and instead launched a price war aimed at Russia, which also refused price control measures. The result was swift — oil prices slid 42% between Feb. 20 and March 9. West Texas Intermediate (WTI) crude, the U.S. benchmark, slid from more than $53 per barrel to $31. At that price, most American wells became unprofitable, shaking the confidence of exploration and production companies.
Little did we know, the worst was yet to come.
Meanwhile, the coronavirus was spreading through Southeast Asia, the Middle East and Europe, and finally to the United States by late January. By mid-March, mere days after the collapse of the oil market, state and federal governments began limiting social interaction because of the pandemic, closing schools and businesses. By late March, nearly all state governments had issued stay-at-home orders, essentially grinding the economy to a halt to fight the spread of the virus. The resulting drop in demand for oil for industrial and commercial purposes was a crushing blow to an already shaken energy sector.
In April, the combination of excess production from the Saudi/Russian price war and slashed demand from homebound consumers dealt a death blow. On April 20, WTI prices plunged to less than $17 per barrel, and WTI futures traded for negative prices. Oil had become worth so little that pulling it out of the ground was a losing proposition. American production companies raced to cut oil and gas production as storage facilities neared capacity. By the end of the month, the number of active oil and gas rigs fell to levels not seen since 1940. Exploration and production companies ceased operations, with some seeking shelter through the bankruptcy courts. The service companies that relied on producing rigs — from sand haulers to roustabouts, inspectors to welders — and the factoring companies that financed them are left staring at the wreckage and wondering how the bottom has fallen out of a huge market segment in only two short months.
A BLEAK OUTLOOK
For manufacturing and service companies in the energy sector, the short-term outlook is bleak. Developing and operating wells are labor-intensive exercises, requiring construction, delivery and handling of materials, skilled trades and unskilled labor. The process of fracking shale requires constant supplies of chemicals and water. All told, these activities require crude prices of more than roughly $40 per barrel for a well to be profitable. With prices significantly below that level and the indeterminate effects of the coronavirus on demand, exploration companies shelved plans and production companies ceased field operations. Continental Resources cut production estimates by 70% for May. EOG Resources is reducing production by 25% and canceling almost 40% of the development of new wells for 2020. Haliburton laid off more than 5,000 workers. Although energy sector workers have been mainly exempted from stay-at-home orders, oil and gas service work has dried up from West Texas to Pennsylvania.
The effect on energy service companies is relatively apparent. Even if employees have been lucky enough to avoid infection, such as those working outdoors in isolated rural areas least hit by the virus, there is waning hope for near-term opportunity. As industry and commerce open slowly and world economic forecasts remain bleak, demand likely will continue to lag behind foreign production and domestic storage capacity. Few are projecting growth in exploration and production for the remainder of 2020, and those companies lucky enough to maintain work will see pricing and payment pressures from increased competition to survive.
THE IMPACT FOR FACTORS
For factors that provide financing to the industry, the challenge is three-fold. First, factors must face the inevitable loss of clients. As in many industries, energy clients are struggling to stay in business. Without prospects in the immediate future, many will either disappear or file for bankruptcy. Although they are usually secured creditors, factors find little joy when mired in client Chapter 7 bankruptcies. The lost volume puts immense pressure on factoring companies with heavy concentrations in energy, including pressure to appease lenders, maintain staff and morale, and diversify into crowded markets.
Second, factors must maintain credit discipline in a rapidly devolving market segment. Debtor bankruptcies spring up daily. Chesapeake Energy, teetering for months, is reportedly considering bankruptcy restructuring following the bankruptcies of Whiting Petroleum and Offshore Drilling. Highly leveraged mid-market players may have little choice but to seek refuge in restructuring. Factors holding significant accounts owed by these debtors, of course, may find themselves in long lines of unsecured creditors. Pulling the plug early risks clients, but pulling the plug late risks enormous losses.
Third, factors need to focus on their employees. These are unprecedented times. The pandemic alone is unnerving and poses frightening risks. The collapse of the oil and gas market has heaped on even more uncertainty. We sympathize with our clients’ struggles and stretch our patience to its limits. But the health and wellbeing of our employees is paramount to our long-term success. While we tighten our belts to weather this perfect storm, we must be mindful that our first obligation is to keep every employee safe. Developing systems, processes and discipline to work remotely and limit health risks is even more critical than protecting against credit and financial threats.
While the immediate outlook is dim, and the near future murky, there is reason to hold an optimistic view. Although these circumstances are unique, challenges to the oil and gas sector certainly are not. For factors that weathered the plunge of 2014 and 2015, we know the industry will come back. If we do things right today, we will be there to provide the financing necessary to rebuild the energy sector later.
Mark Zitzewitz is senior vice president and general counsel of TCI Business Capital.