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01.07.2016

Upstream Energy Sector Under Pressure for 2016

Paul Garrot - Vice President, Product Line Manager – Energy - Ironshore Specialty Casualty

U.S. exploration and production companies are being challenged by the cyclical downturn in commodity prices which are expected to continue through 2016.  Energy’s upstream sector is directly impacted by oil commodity prices that are at lows not seen since 2009, reflecting the gradual decline in the trading markets.  Three mitigating factors that will determine the longevity of this cycle are: 1) OPEC countries’ stance in managing production; 2) lifting costs’ strain on productivity; and 3) recovery of the global demand for energy particularly in China.  With many U.S. upstream energy companies facing consequential economic circumstances, insurance companies are in the midst of a soft, competitive market.

In prior market downturns, OPEC countries – informally led by Saudi Arabia as the largest regional producer - would stabilize pricing by cutting production.  As evidenced by OPEC action, or inaction, in 2015, the twelve nation cartel signaled its intent to follow supply and demand theory.  OPEC is allowing the market to set the price of crude oil rather than slowing supply to bolster the price.  In particular, Saudi Arabia is not willing to sacrifice market share to prop up the rest of the cartel.  The U.S. domestic upstream sector with an overabundance of production supply and reserves is struggling to adjust output while balancing financial uncertainty.  Sector dynamics surrounded by the emergence of economically efficient fracking and technological advancements in fuel alternatives have further increased domestic upstream production.  The U.S. has become nearly energy independent, forcing the crude that had in the past been imported into the U.S. to seek other markets at a time of slowing global economic growth.  Another key factor contributing to the global over-supply mix will be the impact of Iranian crude, which will be coming to the market due to the lifting of economic sanctions over its nuclear program.  

Commodity markets base pricing on various grades of crude, led by the Brent and Western Texas Intermediate (WTI) benchmarks.  By year end 2015, the WTI oil price was hovering around $35-$37 per barrel, a drastic reduction from mid-2014 when oil prices exceeded $100.00 per barrel.  Favorable pricing in 2013 and 2014 triggered heightened production of U.S output that represented an 80 percent increase over previous years.

Lifting costs to produce crude, maintain wells and transport product average approximately $40.00-$45.00 per barrel in the U.S.  but Saudi Arabia, in comparison, enjoys lifting costs of just $9.00 to $15.00 per barrel.  For U.S. domestic companies, depressed profitability margins and expiring hedging contracts in 2016 are driving strategic acquisition/divestiture activity, reduced drilling, well abandonment and even bankruptcy.  While the larger companies in the sector, the “majors,” are equipped to withstand a prolonged downturn, mid-level market producers are confronted with survivability obstacles. 

Insurance carriers dedicated to the upstream energy industry recognize that the insureds’ risk profile has altered the sector’s coverage landscape.  Market tickle-down factors resulting from the downward trend in crude and natural gas commodity prices have stifled drilling new wells and completing wells that have been drilled.  Wells with lifting costs that exceed the commodity price have had their production shut-in.  All of this has instigated the unavoidable: distressed revenue, inevitable unemployment and underutilization of equipment across the industry.  While the insurance market has ample capacity for this sector, premium reductions have become the norm due to the decrease in exposures of well counts, payrolls and revenues.  Comprehensive underwriting solutions are addressing the evolving complexities of the current risk paradigm.  
 
In summary, the outlook for the upstream sector recovery is cloudy.  On December 18th, President Obama signed the Congressional spending bill that included a provision to lift the decades-long ban on overseas export of domestic oil, which had been in effect since the Arab oil embargo in mid 1970s.  However, for the foreseeable future, U.S. exploration and production companies must be nimble in order to adapt to ever-changing global energy influences.

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