Economic headwinds: Oil and gas

The energy industry consists of numerous, complex sectors, each with its own ecosystem and variables that determine how it is positioned in the overall economy. However, it is safe to say that the oil and gas sector in particular has fared better than the overall economy during the recent period of inflation.

While the correlation between inflation and oil prices has weakened over time due to society’s declining dependence on oil, it is still fair to say that higher oil prices contribute to inflation as oil is still a major input into our economy. This correlation was evidenced as crude oil and natural gas prices have reached record highs during the recent inflationary period. Higher prices benefit oil and gas companies, but not if those prices are too high. While the break-even price has dropped over the last decade thanks to efficiencies brought on by technology, there is still a sweet spot where it is beneficial, or profitable, for oil and gas companies to do their core job—produce oil and gas. The bottom line is that high prices increase profit margins, until they don’t. When prices are high enough to significantly dampen demand, the industry will ultimately suffer as depression-like conditions set in.

“We did see some demand destruction during the most recent price surge, specifically with respect to gasoline prices, indicating that any reversal driven by a natural event or intensifying geopolitical tensions will likely result in another round of demand destruction,” says Joe Brusuelas, RSM’s chief economist.

Oil and gas companies experienced severe losses earlier in the COVID-19 pandemic when commodity prices were low. As a result, they exercised extreme capital discipline in an effort to protect their shareholders and position themselves for a post-pandemic comeback. Despite the volatility that the industry has experienced over the last three years, higher commodity prices and increased production coupled with cost controls have landed oil and gas companies in a strong position.

While middle market companies’ results may not be quite as positive as those of the majors because their pockets simply are not as deep, midsize companies are certainly experiencing improved free cash flow and bottom lines.

However, these peak revenue flows could be in in the rearview mirror, making sustained capital discipline more important than ever.

Top challenges for the oil and gas sector are material prices and volatility

Increasing production does not come without its challenges, though. Inflation has increased the price and hampered the availability of many of the materials that the industry relies on to operate. The price of drill pipe, for example, has increased 90% to a record $4,150 per short ton compared to $2,300 a year ago, according to Bloomberg. With cost containment key to the success of oil and gas companies, they must focus on making up for elevated costs with efficiencies and technology in other areas of operation.

Despite healthy financials and an increase in activity, the industry still faces an enormous amount of uncertainty. In an industry where volatility is the biggest challenge, the ever-changing events and circumstances affecting the industry are always top of mind. Geopolitical tensions such as the war in Ukraine and unrest in Iraq continue to cause supply concerns. Simultaneously, recession fears escalate amid rising inflation and interest rate hike speculation.

How oil and gas companies are mitigating the impacts

As middle market energy companies monitor these factors, it is key that they maintain a level of capital discipline and remain conservative in their operations. Ramping up production in a period of inflationary pressure requires a laser focus on balancing operations and stakeholder expectations.

According to Bloomberg, independent shale producers’ free cash flow was up 98% in Q2, while spending was 10% below the 2018 peak despite these higher prices, signaling that producers are doing just that—remaining cautious and positioning themselves to overcome another slowdown.