Which Companies Will Weather the Oil Price Storm

April 1, 2016Energyby East Asia Forum

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Not all companies are equipped to weather indefinite low oil prices.

It is possible that prices may jump again but they will almost certainly stay below US$50 per barrel throughout 2016. Speculation may increase prices but, without any substantive changes in supply-and-demand, any rally will be short-lived — as has happened several times since August 2015. The fundamental changes in the global oil market necessary to solve the current oversupply problem, unfortunately, still seem a long way off.

OPEC and Russia are unlikely to cooperate to cut output this year. Even if they do hammer out a deal to freeze production, this will not immediately restore balance in the global oil market. In addition, Iran insists on boosting oil production, which may influence other oil producers to not agree to a freeze.

US production will also delay this long-awaited global rebalancing. On the one hand, output is declining and may decrease by 500,000 to 800,000 barrels a day as projected by the Paris-based International Energy Agency and US Energy Information Administration. However, this predicted drop will probably not materialise for at least another eight months because of improvements in well productivity. Even if prices jump to/above US$50 per barrel, producers will use the re-fracturing technique at a larger scale and bring thousands of drilled but uncompleted wells online. This could increase US output by approximately 600,000 barrels of oil per day within a few months, causing prices to sink again.

A continued reduction in output in the rest of the world alongside growing global demand together, could arguably help narrow the supply-and-demand gap by up to 1.2 to 1.4 million barrels a day. However, this process would probably take several quarters. In the short run, oversupply problems cannot be solved; prices will almost certainly remain depressed this year.

For the foreseeable future, US producers will remain in a difficult financial situation. A large number will continue to lose money. As our economics study on more than 32,000 wells in the US prolific tight oil plays reveals, at current prices of around US$40 per barrel, more than 60 percent of those wells are unprofitable. In addition, even if the prices jump to US$50–60 a barrel, 30–40 percent of those wells would still have a negative net value. Many conventional oil producers are expected to contend with conditions that are more arduous. In the US Gulf Coast, for instance, the average breakeven costs are very high at around US$70 per barrel.

In light of these difficulties, some companies have added new hedges, but the scope for this is limited. Our survey of 40 top medium and small oil producers in early March indicated that, on average, these producers had hedged only 32 percent of their oil production for 2016. Worse, 25 percent of these producers were not employing any hedging strategies at all, leaving them exposed.

Depressed prices and insufficient hedging strategies will inhibit the ability of cash-strapped producers to retain their borrowing base. Many US companies have obtained reserve-based loans in order to finance upstream activities. Banks providing such loans typically re-determine the borrowing base twice per year, usually in spring and fall. As the value of reserves is already being impaired by depressed prices and inadequate hedging strategies, it is highly likely that banks will lower the borrowing base. Companies have been proactively renegotiating with lenders wherever possible, but the scope for greater flexibility is limited.

Most concerning of all is mounting corporate debt. Many producers have accumulated tremendous debts that need to be repaid. In addition, liquidity problems present significant obstacles to their debt repayments. More than 60 percent of US producers’ ratio of debt to their earnings before interest, taxes, depreciation and amortization (EBITDA) is above 6, indicating that their capacity to repay their debts is low. Many corporate bonds are also being traded at deep discounts, further heightening the risk that companies may default.

Overly leveraged producers have the option to offer a new security, such as a junior-lien debt, in exchange for cash or existing senior unsecured debt. They may also seek to sell assets to provide additional liquidity. However, if depressed prices continue, many will not be able to weather the storm. More bankruptcies are likely in the coming months.

Oil not out of the doldrums any time soon is republished with permission from East Asia Forum