Effect of Commodity Prices on the Engineer, the Industry, and the World
Interview with Ward Polzin, CEO of Centennial Resource Development
How would you describe the commodities industry and its role in the oil and gas sector?
The oil and gas commodities industry, i.e., the trading of oil and gas, is highly critical. Oil and gas being traded as a commodity signifies that it is a global industry. The trading of commodities—not just oil and gas, but any commodity—is a global endeavor. As such, the price is set by a global market. To me, that is the most critical factor about oil and gas. Interest rates and oil prices are probably the two variables that have the greatest impact on the global economy. Interest rates more so, but it also points to the importance of oil as a commodity.
Oil and gas as a global market really took off in the 1970s and 1980s with the rise of the Organization of the Petroleum Exporting Countries and the development of technology that physically allowed the barrel to move. The advent of the Internet and electronic technology that facilitates the stock and trading exchanges of the world also fueled the globalization of oil and gas trading.
What is the most common misconception about commodity prices and trends, specifically for oil and gas (either publicly or within the industry)?
There is an assumption that traders set the price. Prices, especially long term, are set by the market’s perception of supply and demand—that is not just traders, but also the end users and the producers of the commodity. There are really three large groups that trade: producers, users, and the “middle men,” or what some people may call traders or speculators. While they do influence prices and add volatility, they do not really set the prices.
The oil and gas industry does not dictate the price at which the products are sold. Which other industries are subject to the same challenge? How do they deal with such uncertainties ?
There are several industries that are similar to oil and gas in terms of selling commodities—gold, silver, molybdenum, really anything that is mined. But I think maybe the industry that has the most in common with oil and gas is agriculture, whether crops (such as wheat) or livestock. The biggest challenge boils down to volatility—it is up some days, it is down others, which brings risk into the equation.
Simplistically, I see three ways (although there may be many more) for companies in the industry to protect themselves from volatile commodity prices. Firstly, you could hedge, meaning you can sell your product at a predetermined price—a forward sale of your product.
Secondly, you can diversify. If you are an oil producer, you have some gas in your portfolio. Or, if you are a gas producer, you can add some oil so that you are not exposed to just one commodity. You can also diversify by basin or country. Different basins have different price discounts so you can minimize some forms of price exposure this way.
Thirdly, you can work on becoming the low cost operator (LCO). If you can do it for less, you can handle the lower prices. We generally think of commodity in the traditional sense, referring to mining, oil, gas, agriculture, etc. But colloquially, people say, “my product has been ‘commoditized,’” meaning that anyone can produce my product. One example is solar panels, now being manufactured less expensively in China than they were a few years ago. Have solar panels become a commodity? Not in a conventional sense, but who survives? The LCO.
As the industry becomes more mature, ultimately, the prices are going to come down for whatever you produce. By becoming an LCO, you can better cope with the volatility.
What are the effects of price decline on the US’ status as an oil and gas exporter?
You have to divide gas and oil and talk about each separately because [the US] is not legally allowed to export crude oil, except to Canada. Each commodity has its own uniqueness in the technical and political challenges it faces to be moved around the world. Oil is legally difficult but logistically easy to move (just put it in tankers!). On the other hand, gas is easier politically, but hard logistically (complex and expensive liquefied natural gas [LNG] tankers). The good news is that now the [US] seems to allow for the export of (refined) condensate, which is a good step toward the ultimate export of oil.
The price decline creates a stronger desire for oil export. When prices are high, you are not as concerned with having access to more markets, but when prices are low, you just want all the markets you can find in which to sell the product. Low prices definitely put pressure on the US government to allow that, and certainly more pressure on oil companies to try and get that changed.
Gas is a good example of this. Since gas prices declined before oil price declined, it is one step ahead. Clearly, the LNG export facilities trying to be permitted and built are an example of that. The desire to export gas happened quicker because prices dropped quicker. Oil is following gas in this, so there is a higher motivation to export oil.
Given that the oil and gas industry is dictated by the price of its products, in your opinion, how important is it for engineers to understand this side of the industry?
Critically important. I guess it is a little self-serving because I have always been fascinated by the combination of finance and petroleum engineering. I have also spent half of my career in the more financial part of the industry. To me, it is natural to want to put the two together. Engineers definitely have that technical mind and quite frankly, if they have an interest in it, they can easily develop an understanding of the financial side.
One of the biggest concerns as a young engineer in the oil and gas industry is layoffs during the downturns. At what point does a company consider layoffs (i.e., why would a company consider layoffs vs. other cost-cutting measures)?
In a downturn, layoffs are not the first thing that happens. First come the spending cuts. Even though people are expensive, wells are more expensive, so the first steps are cutting capital, drilling less, and slowing down projects. The second cost-cutting target is lease operating expenses. These are the costs of maintaining and operating property and equipment on a producing oil and gas lease. Third is the cutting of general and administrative expenses (G&A). The primary G&A expense is people.
The next obvious question as a professional in the industry is how to deal with it. In difficult times, if you are already employed, you want to make sure you are working on the best assets, because the company is going to slow drilling in the worst assets first. You do not always control where you are posted, but if you can, working the asset that stands the test of time is certainly a good place to be.
For the folks who are still trying to find that job, I can relate to that extremely well because I graduated in 1984 (from Colorado School of Mines) when there were minimal jobs. I already loved the finance side and I could see it coming a year ahead of time so I went and got a business degree. Getting a higher education meant the addition of another skill to my resume. Graduating from business school in 1986 was even worse, but thankfully I had two degrees so that set me apart. There is nothing wrong with going back to school, but I have always advised folks against getting an extra degree just because it looks better on your resume. You better like learning. Pursue something that truly interests you. If you have that interest and desire, go for it, do it right now, and you will be that much better and more competitive coming out of graduate school.
Deciding on whether to pursue a business degree or a technical degree beyond the undergraduate level is one reserved for the individual. A master’s in petroleum engineering would not have been right for me, because I just loved combining the finances with the engineering. Either is a good route; it is just a matter of personal preference.
What personal advice can you give young engineers about working in the volatile oil and gas industry?
One can use the same strategies that oil and gas companies use to minimize risk to navigate the industry.
Hedge. How an individual hedges is education. Make sure you are constantly learning so that you are not pigeonholed into only knowing one part of the business.
Diversify. As a person, diversifying does not mean you get a different job; it just means that you make sure to keep your petroleum engineering skills broad. Yes, have a focus—maybe you are a completions engineer or a reservoir engineer—but you should be learning all you can about the other engineering disciplines. Even though you do not become an expert, it is important to appreciate and understand all the parts of the puzzle in getting oil out of the ground and moving it.
Be an LCO. From an individual’s standpoint, it means bringing more value as opposed to cost to your employer. You have to be able to do more than what is being asked of you, digging deeper to understand the numbers a little bit better, and taking a project further than “the answer.” It is not about having the answer; it is about what you do with that answer—provide a solution and implement it.
In a 2012 The New York Times Op-Ed article titled “The High Cost of Gambling on Oil,” Joseph P. Kennedy II states, “[speculators] add little value and lots of cost as they bid up the price of oil in pursuit of financial gain. They should be banned from the world’s commodity exchanges, which could drive down the price of oil by as much as 40 percent and the price of gasoline by as much as $1 a gallon.” Any thoughts on this statement?
I disagree with the strength of the statement that Kennedy makes. The speculators and traders who were operating in 2012 are still operating today. This article probably would not have been written in 2015, yet the speculators are doing today what they were doing then. Speculators did not drive oil prices up and they did not drive it down. If you believe in capitalism, I think you need to have these exchanges and traders.
Usually speculation has a negative connotation, but I do not treat it that way. Exchanges and traders are just a part of a capitalist system. If you have ever bought a stock or mutual fund, you are speculating. If you are buying it, you think the price is going to go up. If you are selling it, you think it is going to go down. If there are more people buying it, it is going to drive the price up, and if there are more people selling, the price is going to be driven down. So I think we are all speculators in lots of ways, but obviously not to the extent that some are. While oil and gas speculators make an impact, they are not the main driver of prices.
One could argue that our dependence on fossil fuels has become crippling. Would you consider gas a luxury resource? In other words, do oil and gas as commodities bear more resemblance to wheat or lobster?
I very much think it bears more resemblance to wheat because it is the lifeblood of our society. Oil and gas is a fundamental resource, but I would say that about all energy, not just oil and gas. Energy drives the world, whether it is renewables, nuclear, or fossil fuels. I do not think that the world’s dependence on fossil fuels is crippling. Based on what I have read, a country’s gross domestic product can be increased the quickest by using oil as compared to all other fuels.
The more mature the country’s economy gets, the less and less it uses fossil fuels and it can begin to switch to other sources of energy. It is a great way of quickly bringing up the quality of life in poorer countries.
There is often a disconnect between the consumers and producers of petroleum. Users of petroleum projects revel in the low price of oil because it means a low cost of gasoline, but to those in the industry, low oil price means job losses and a jeopardizing of economic security. What would you recommend to close this gap in understanding?
Boy! That is something we have been trying to do for decades. There are some standard industry responses to that. We have not been very good, as an industry, at communicating our role in the economy and jobs, but we are getting better. I think just about anybody would say that. More specifically, how do you get better? Make it more local.
There are a lot of commercials and data available at the national level. With states like North Dakota, Colorado, and Pennsylvania seeing big developments in recent years, organizations have been created in response to bridge the communication gap between industry and the public. Coloradans for Responsible Energy Development, for example, really brings it down to the state level—here is the impact in our state. Individual companies can take it one step further. Here [in Colorado], companies like Noble Energy, Anadarko, and Encana have held public meetings at the county level, bringing industry employees out to the community. The more local you get the better; people can really see examples of oil and gas working well with the community.
I also think it is important to educate the public about how crude oil byproducts affect their everyday lives. Outside of the obvious contributions to transportation, lighting, heating, and cooling, it is making sure people understand how much of their world is built on fossil fuels.
Young engineers make great ambassadors for the industry. You know a lot; even though you may not appreciate it, you are an expert. You need to be unafraid to speak up and politely debate the topics with people.
From a social responsibility perspective, can hydrocarbon consumers and producers strike a balance where profit margins are met and sustainability can be achieved? In other words, can oil and gas companies still make money, but take an active role in promoting conservation of natural resources and the pursuit of renewable energy resources?
I think we can achieve that balance. When you are in the industry, you may not pay attention to the effect of high oil prices on the economy. Conversely, those who are not in the industry may not appreciate the tradeoff. In a USD 50/bbl world, there is just no way oil and gas companies make enough money long-term. But at USD 120/bbl you can make, in a sense, too much money and our industry will be targeted. I think there is a happy balance where we make money as companies and the greater society has a strong economy. At USD 80/bbl or USD 90/bbl oil, economies zoomed right along, but I think at USD 120/bbl oil, economies started to hurt. There definitely is a place where we can meet in the middle from a profitability standpoint.
There is a balance we have to strike in the lifestyle we lead, not just in the US but in the world. We cannot innovate—create the Internet, develop new medicines—if we are a poor society. A lot of that ability to innovate stems from our access to cheap energy.
Ward Polzin is chief executive officer of Centennial Resource Development, a Denver-based private oil and gas company backed by Natural Gas Partners. Polzin has more than 25 years of experience in the upstream oil and gas industry in engineering, commercial, investing, and transactional roles. Prior to forming Centennial, Polzin served as a managing director and founding partner in Investment Banking at Tudor, Pickering, Holt & Co., where he spearheaded the firm’s exploration and production asset acquisition and divestiture practice since inception. Previously, Polzin served as the US country manager at Enerplus Resources and as a managing director with Scotia Waterous & Co. Polzin has been an SPE member for more than 25 years and is also a chartered financial analyst. He holds a BS in petroleum engineering from the Colorado School of Mines and an MBA from Rice University.
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23 April 2018