Rubber suppliers to oil, gas sector likely to be hit by downturn

FORT WORTH, Texas—Polymer companies that have a heavy emphasis on supplying shale oil and gas wells will be hurt the most by the ongoing price war that has seen oil prices plummet to around $30 a barrel or lower.

That's because the shale players—particularly the smaller companies—can't sustain future investment in new wells at these prices, according to Neil Mendes, CEO of Alpine Polytech, a Fort Worth-based material and equipment testing firm, and also chair of the Energy Polymer Group.

The price drop involves Russia, Saudi Arabia and other geo-political forces that have seen oil selling at levels it hasn't seen in the last five years. Basically, the Russians hiked oil production, he said, to try to hurt shale producers and reduce producers' footprint in the market, while the Saudis, unhappy with Russia not sticking to agreed-upon production limits, boosted production as well.

It's a bit like what Saudi Arabia tried to do in the 2014-16 timeframe, but with some financial twists. "The difference potentially is these (shale) companies do not have that much cash," Mendes said. "They're operating on fumes to begin with, and this oil price down to $30 a barrel is not sustainable for a lot of them."

The economics of shale and off-shore oil production plays a big role in how the whole situation is playing out. First, shale wells are easy to turn on and off, unlike the massive rigs erected offshore that cost billions to put in place. Mendes said once those rigs are in place, the actual price to produce a barrel of oil probably is less than $15 a barrel, discounting the upfront costs.

"So once they're going, they're cheap," he said.

But for shale it's a whole different story. Even well-run companies break even around $40 a barrel to produce oil from the shale wells. "And they have to constantly drill wells, because they only last for a few years, in order to get oil out of the ground," Mendes said. "At $30 a barrel, they're losing $10 a barrel from break even. There are a lot of shale companies that don't have the cash to even operate basic drilling and completion of (new wells). Whatever they have in the ground, they can pump it, because they've already spent most of the money, and create some cash flow. But they can't replace that. They just don't have the cash, and there's just no money out in the marketplace."

And prior to the last month or so when the coronavirus pandemic began to have a greater impact on the world's economy, he said the oil and gas sector was by far the worst performing sector in the stock market—shale in particular and oil and gas overall. "The returns are terrible, and that's when prices were $50 a barrel (or higher)," he said.

Even oil industry giants such as ExxonMobil and Shell were not performing anywhere near the rest of the stock market. And shale players were much worse off.

"They constantly need cash," Mendes said. "They're not generating enough free cash flow to really give a return back to investors."

Trickle-down economics
As the shale fields suffer, the rubber and plastic products firms that supply the market with seals, bearings, hoses and other goods also will see a downturn in their business.

During the heyday of shale, those suppliers benefited greatly, though much of it was for lower-margin, commoditized products, according to Mendes. Typical elastomers used in the sector included nitriles, NBRs and HNBRs, while the offshore rigs utilize such materials as fluoroelastomers and Aflas.

"The great thing about the shale play for the polymer business is it's a huge amount of consumption, because they're constantly drilling wells," he said. "Margins are much better offshore but with much lesser quantities. Companies heavily dependent on shale are really going to take it on the chin in this downturn. Consumption will be way off. People are not going to drill new wells and lose $10 a barrel."

The shale-based firms will continue to pump existing wells and generate some cash flow because they've already made the upfront investments, but they won't drill new wells because they lack the capital.

This isn't the first time there has been a play to put the shale players in a bit of hurt. But it's also clear that the sector hasn't turned out to be the boon market that once sparked an avalanche of investment dollars.

It was, in fact, the Saudis who tried to put pressure on the shale players, who were gaining market share quickly. The nation boosted production in 2014 and into 2015, bringing oil down to roughly $26 a barrel. Mendes said at that point, the Saudis decided it wasn't good for anybody, particularly because the shale players didn't go out of business.

"They were fairly resilient," he said. "They had cash built up, and they were able to wait the Saudis out. Shale was still kind of new. I don't think people realized how much money shale was constantly needing. There was a lot of private equity money in there, and people were still willing to put money into shale."

When Saudi Arabia backed off, oil settled into the range of $60 to $65 a barrel for Brent crude and $55 to $60 for WTI crude, according to Mendes. That allowed shale producers to make a profit.

But then the Russians wanted to take back some market share from shale, and the Saudis got in the fray. He said there's no way to tell how long it will last, adding that it could be weeks or months, but doubts it will last more than a year.

"At the end of the day, (the Russians and Saudis) are both pumping a lot more oil than the market needs, especially with the coronavirus and demand destruction going on top of it," Mendes said.

Offshore a different ballgame
For those supplying offshore rigs, though, the economics are much different. "They take a long time to get going and a long time to slow down," the Energy Polymer Group chair said.

For example, ExxonMobil has committed roughly $35 billion a year for the next five years to put in place its offshore oil field in Guyana, north of Brazil. The energy giant started its first oil production in the first of multiple offshore projects in December.

"That oil, once it comes online, is cheap," Mendes said. "They won't tell you how much, but people are guessing in the $15 to $20 a barrel range. So they can make money in almost any market."

Those offshore investments will continue for the foreseeable future because there already has been so much money spent. And most of the capital spending is for several years down the road, so it doesn't matter if oil is $30 a barrel now.

"Shale is cheap to get into and also cheap to turn off," he said. "You can just send everybody home. You just don't drill anymore. Offshore, you have this rig which you spent billions of dollars for, so you're not going to pull back."

For shale, however, the economics are beginning to catch up. The private equity firms and venture capitalists—those so willing to throw money at shale when its future looked bright—are seeing they aren't getting a return on their investment. Mendes said they finally are to the point where the investment funds are drying up.

Just last year, Occidental Petroleum Corp. acquired Anadarko Petroleum Corp. in a deal valued at $55 billion, including the assumption of debt. The combined value of the company in recent weeks was in the $15 billion range.

The good news for shale is that ExxonMobil and Chevron have invested in shale, and though Mendes said both announced plans to cut down some on shale investment this year, they're not leaving the field altogether. But the smaller shale players are at particular risk of not being financially viable going forward.

So suppliers with exposure in shale will take a hit, but those focused on the higher-end, offshore oil market will be in a more stable condition. "Of course, others are trying to chase that business as well, but it's harder to get in on offshore business, with higher-grade materials and a lot of testing that goes into it," he said.

Testing firms like Mendes' Alpine Polytek will be impacted some, but he said there isn't that much testing done for shale as the drillers aren't as concerned about the performance of the rubber and plastic materials. "But offshore, where you have billions of dollars invested and the rubber and plastic might be the weakest link that's critical, they will spend money to make sure this material will hold up because it could stop them from producing $100 million worth of business," Mendes said.