Too Much Debt, Too Much Capacity (Mal-Investment), Then Inevitable Bust

The Western banks that financed commodity production are insolvent, though few yet realize it.

Debt

Like the flawed analysis of the CDO market in 2007 the conventional view is that the subordinated lenders may be in trouble, but the senior banks with the senior debt are safe. Deloitte has just punctured this myth with a report stating the obvious: “Not even a wave of oil bankruptcies will shrink crude production.” This is because oil companies go bankrupt not when the price of oil falls below the cost of production, they file much sooner: when the cash flow is no longer sufficient to pay the debts. After bankrutcy, the creditors become the equity holders and get any remaining cash flow–they don’t turn the well off. Not until the price sinks below the raw cost of production–and then for a time necessary to exhaust any capital reserves–does the well actually close. In other words, the oil spigot will not turn off until all residue of the debt is completely erased, and the same dynamic applies to the other commodity sectors.

Myrmikan_Research_2016_02_22

Myrmikan has pounded the table since August that history is not rhyming but repeating nearly perfectly the 1929 model–first overcapacity drives deflation, then market collapse, then more deflation, until finally a dramatic devaluation of the currency to resolve unpayable debts. The value of capital falls to levels that seem almost inconceivable. This pattern has repeated without fail since the time of Solon, in 594 B.C. Athens, and it is doing so again now.

Deloitte study says 2016 is a period of tough financial and strategic choices for E&P companies

Published 17 February 2016

With more than $150 billion in debt on their balance sheets, nearly 35 percent of pure-play exploration and production companies (E&P) listed worldwide, or about 175 companies, are at high-risk of slipping into bankruptcy in 2016, according to a new Deloitte study, “The Crude Downturn for E&Ps: One Situation, Diverse Responses.”

The outlook is almost equally alarming for about 160 other E&Ps that are less leveraged but cash flow constrained.

Deloitte vice chairman and US oil and gas sector leader John England said: “2016 will be the year of hard decisions. We could see E&P bankruptcies surpass Great Recession levels as companies struggle to remain solvent.

“Access to capital markets, bankers’ support and derivatives protection, which helped smooth an otherwise rocky road for the industry in 2015, are fast waning. A looming capital crunch and heightened cash flow volatility suggest that 2016 will be a period of tough, new financial choices for the industry.”

Seeing the cash crunch, E&Ps worldwide have saved or raised cash to the tune of $130 billion, since the oil price crash. Surprisingly, two-thirds of the savings have come from non-capex measures such as asset sales and equity issuance.

However, considering further equity issuance and asset sales will come at much lower prices, the report notes that E&Ps worldwide are entering 2016 with the only option of cutting their already reduced dividends and share buybacks.

“Considering the industry will have fewer financial levers to pull in 2016, operational performance will be the key to sustainability and growth,” said England.

“There is still more that can be done by oil players, particularly large ones, to reduce costs. Prices will eventually rebound and companies need to focus not only how to survive, but also how to position themselves to thrive for when things turnaround and demand picks up.”

One of the key ways companies have managed to remain viable has been through the reduction of production costs, starting in 2015. Today, about 95 percent of production costs (lease operating expenses and production taxes) of U.S.-origin players operate below $15/boe, versus 65 percent in 2Q14.

The report states that questions on current breakeven prices and near-term cash flows should give way to the future return on capital employed (ROCE) potential of the industry. As the industry improves performance on costs/efficiency, its future emphasis will not be about its ability to make profits at low prices, but generating sufficient ROCE on a large base of devalued investments made in the past.

Further, economies of scale and scope appear to be benefiting natural gas players more, reflected in the widening gap between large and small gas-heavy companies and marginal cost differentiation between large and small oil-heavy players.

That noted, spending cuts in 2015 and 2016 – the first time since the mid-1980s that industry will reduce capex for two consecutive years – will likely have a substantial and long-lasting impact on future supplies and open new chapters in the geopolitics of oil. E&Ps risk slowing the conversion of resources to reserves in frontier locations and the capex required to maintain aging fields and facilities, the report warns.

The report further anticipates that future M&A activity will most likely go beyond the typical buying reasons of the past-preference for oil-heavy assets and buying for growth/scale. Companies that prioritize returns over size, have a balanced and flexible production profile over a deep inventory of non-producing asserts, and give thought to economies of scope over economies of scale will most likely thrive when the price environment improves.

Deloitte Center for Energy Solutions executive director Andrew Slaughter said: “There is no silver bullet solution that applies to the whole industry; in fact, the landscape has never been more complicated.

“Each company has its own set of unique factors to consider – from issues specific to each producing region and asset, to various states of financial circumstances. Staying solvent will require the same level of perseverance, innovative thinking and creativity as the technology breakthroughs that led to the boom in supply we have seen over recent years.”

Too Much Debt, Too Much Capacity (Mal-Investment), Then Inevitable Bust by CSInvesting