Anyone who has even casually glanced at the financial news in recent months is already well aware of the big story today—global oil prices have fallen dramatically. At their lowest levels in six years, and at 50% cheaper than the average over the last 4 years, this is a huge story, and one that is bound to end badly for certain companies in the oil and gas sector. But aside from waiting to see who files for bankruptcy protection, how is one to know the players that are the most vulnerable? Well, it looks like the portent of doom for the oil industry will be the same as it was for those companies that precipitated the 2008 financial crisis: revolver raids—those sudden notifications to companies that their secured revolving credit line has just been significantly reduced.
Lenders are not so keen on renewing credit to companies whose products can only be sold at a much reduced price than when the size and terms of the credit were negotiated. And on the flip side of Polonius’ nugget of wisdom for young men striking out on their own, oil and gas companies do not want to be borrowers who are too dependent on their lines of credit for basic survival. Like a worker whose paycheck is suddenly and drastically cut, they simply won’t be able to make ends meet.
According to a recent Bloomberg article, about 10 shale oil firms facing reduced credit lines are already in danger of not finding some sort of backstop financing to keep going. April just happens to be the month in which many lenders reassess energy company collateral values, and those collateral values primarily hinge on the value of the company’s estimated reserves—the amount of oil and/or gas they should be able to profitably extract from their lands. With lowered values, the size of the credit lines shrink accordingly. For some, this may simply mean scaling back growth plans. For others, however, it’s a trigger for a dreadful feedback loop—they won’t be able to afford to drill as much, thus they will produce less. Lower product volume at lower prices means even lower revenues and then even lower credit lines and, well . . . you get the picture.
Shale oil happens to be a very precarious business prospect to begin with. Why? Because one is not simply taking oil out of the ground and shipping it in tanks to be refined—it is a matter of taking rocks (kerogen shale, a sedimentary rock), and extracting oil from them, an oil that still requires the removal of sulfur and nitrogen, and the addition of hydrogen, to be ready to send to the refineries that produce most of the fuel products we are familiar with and rely upon. Thus, it is a very high energy-consuming process, with a lower net-energy yield (the difference between the amount of energy produced and the amount of energy required to produce) than that of traditional oil.
This makes for a tiny silver lining at the moment—new fuel purchases for the pumping, purifying, and shipping are reduced. However, some of the fuel still being used today was negotiated for purchase when prices were higher, and some of the aggregate energy needed for production has already been consumed in the creation of the vast infrastructures required to run these massive extraction projects—infrastructure often built on credit. And not only was some of that infrastructure created in a higher-priced environment, it was all created with an expectation of higher oil trading prices.
So, where does that leave us? Shale companies with strong balance sheets and high quality reserves (less processing required) should fare much better. Those with weak balance sheets and lower quality reserves . . . well, watch out.
There are larger ramifications than just an industry in trouble. “Energy independence” is much-touted as a strategic priority for the U.S. This has led some to look toward a response similar to that made to the financial meltdown: an industry bailout. Steen Jakobsen of Saxo Bank—who accurately predicted the collapse of oil prices—is among those who predict some form of U.S. government bailout. Others, however, are adamant that lingering public acrimony over previous bailouts will preclude that from happening, and that traditional restructuring processes like buyouts, bankruptcies, and the like will sort out the mess.
Old Polonius may have been less a man of wisdom than a regurgitator of platitudes, but we still remember his precepts well, especially his closing admonition: “To thine own self be true.” And when it comes to oil and gas investments these days, the application seems to be that one should be extraordinarily vigilant and thorough in diligence, lest one’s investment turn into a negative net energy yield.
The editors and editorial board of DailyDAC include preeminent restructuring and insolvency professionals, journalists, and editors. They are devoted to providing reliable and plain English education and deal intelligence about assignments, corporate bankruptcy, receiverships, out-of-court workouts and similar topics.
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