CERAWeek by IHS Markit

Cure for oil stock bust? Issue more shares

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In the game of survival, oil drillers have cut capital spending in half this year, but they have also created a gusher of new stock offerings in an effort to protect their balance sheets.

"They're trying to position themselves for — the phrase is — 'lower for longer,'" said Imperial Capital analyst Kim Pacanovsky. "Lower for longer is getting worse than we thought it was. Most companies are thinking, not so much about a recovery to the $70 range, but oil for lower for a long amount of time. They would be reticent to take on debt, but if they have been able to tap the market for equity, that's what they're doing. ... It gives them a cushion. It gives them liquidity without taking on additional debt, and just staying power."

Even with oil's sharp 30 percent rally since Feb. 11, industry experts do not expect much higher prices, and many are still hesitant to call a bottom in the market. So they continue to plan for the worst.

Equities have taken a pounding, with some stocks at decade lows. The S&P 500 energy sector is down 41 percent from the June 2014 high in West Texas Intermediate crude prices. WTI was just above $34 per barrel Wednesday, and at its low, was down more than 70 percent from its 2014 highs.

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According to IHS, share offerings from North American exploration and production companies already totaled about $5 billion this year. That was already a quarter of last year's total volume, and there have since been more, including Marathon's 145 million share offering this week. Marathon said it is using the proceeds to strengthen its balance sheet and for general purposes, including part of its capital program. It's stock was down more than 3 percent Tuesday.

"It's survival basically. They are in survival mode. They are basically throwing everything overboard. The only thing they're keeping is the ship. These companies want to survive. They're using everything in the book. They are basically buying a new lease on life. It's not what is good, it's the least bad options," said Fadel Gheit, senior energy analyst at Oppenheimer. Companies have slashed dividends, and Gheit said they are now issuing more stock, after abandoning share repurchase programs as crude prices kept falling.

"It's capitulation," he said. Analysts, however, expect to see more bankruptcies and a rush of merger activity, as well as a more stable oil price before the industry can begin to heal.

Drillers had been active in the debt market, but in the high-yield arena, where the bonds of many are trading at distressed levels, issuance has come to a standstill. According to Informa Global Markets, there was already about $350 million in new energy issuance at this time last year, compared with zero for oil companies this year. In the spring, when oil prices moved above $50 per barrel, there was a surge in activity, and 2015's high yield issuance totaled $17.95 billion.

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The investment grade market remains open to issuers, and this week Exxon Mobil issued $12 billion in bonds, the bulk of this year's $20 billion in energy issuance. The Exxon bond prices were higher during the first day of trading Tuesday, as spreads tightened by 10 basis points or more. Tudor Pickering Holt was quoted as saying the company looks like it is poised to make a major acquisition, but Gheit said the $12 billion could also easily cover Exxon's dividend.

At ExxonMobil's analyst day Wednesday, the company said it would cut capex by 25 percent and CEO Rex Tillerson said the company could increase spending if the right opportunities arose. ExxonMobil's spending peaked at $42.5 billion in 2013, and it said 2017 capital spending will be below its planned $23 billion for this year.

"Oil prices humble even the mighty, whether it's Saudi Arabia or Exxon, it doesn't matter. It's like a tsunami. No matter how big you are, you're going to be pulverized," Gheit said. He said issuing stock for some companies is the path of least resistance.

"They cut dividends to make it easier for them to issue stock," said Gheit. "Their financial position improves significantly by doing so."

Pacanovsky said some companies will ultimately become more attractive because of the share offerings. "It's survival. Are you diluting shareholders? Yes. It's a survival tool at this point," she said.

"I think in general, they're so overly leveraged that basically what we've been saying is anyone that can issue equity is going to issue equity," said Pacanovsky, who follows small cap E&P companies. "Some of them have done well after issuing." She said Newfield Exploration is one name that performed better after its offering. It also is among her top picks in the sector as are Carrizo Oil and Gas and Callon Petroleum, based on the combination of their liquidity and growth.

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Some companies have not gone the route of stock offerings. One of those is Anandarko Petroleum, which has managed declines with a 5 percent production cut this year. It has also benefited from asset sales and is focused on selling $2-3 billion in assets this year, according to Macquarie Research. Macquarie, in a report Wednesday, said Anadarko may avoid an equity offering again next year, as long as it can raise sufficient funds from selling assets and the debt market reopens, allowing it to refinance.

According to Citigroup, the companies it follows are shaving 2016 E&P capital spending by 50 percent from last year's level. Citi's analysis of the plans of 52 companies showed that total worldwide oil production is projected to decline by 3.5 percent from 2015. U.S. production is expected to decline by less.

"U.S. oil production for a sub-group of 43 companies that break out U.S. oil volumes and which represent nearly 45 percent of total domestic oil production is expected to decline 2.8 percent year over year, in aggregate," the Citigroup analysts wrote.

E&P companies also face bank redeterminations in April. Pacanovsky expects the banks to cut back on available credit. "Companies didn't take a big cut in the fall redetermination but being that there's more acceptance for this lower for longer scenario, I think the banks will be less forgiving. I think we will see a much bigger cut," she said.

She said she is constantly reviewing the companies she covers and has dropped some because they became too stressed or were forced to initiate a restructuring. "If their liquidity is not sufficient to cover spending in a very distressed pricing environment in the next two years, then they're going to face difficulties," she said. She weighs the liquidity companies have access to versus the outspend, or the difference between capital expenditures and cash flow.

In the small- to mid-cap sector, many companies were already at risk of or violating their borrowing covenants and could not take on more debt, she said.

In a report on oil services companies, JPMorgan analysts also noted the bank reviews, mentioning Superior Energy Services, Forum Technologies and Now Inc. "Banks are signaling liquidity cuts even for those with sound balance sheets (SPN, FET, DNOW), and already loosened debt covenants could warrant further renegotiation. While we think most can manage debt loads through the trough, until the macro outlook firms, balance sheet durability should continue to garner a value premium," the analysts wrote in a note.

Pacanovsky said the U.S. industry has been a victim of its own success, and the recovery has been slower because drillers became more efficient. The expected decline in overall U.S. production was slow in coming.

"For the same amount of dollars, you get more initial production coming out of a program. All of this progress that the industry has made in a sense is coming back to bite them," she said, adding that companies could be making cuts and cap ex reductions but see actual production increases.