Oil collapse couldn't come at worse time for industry

The U.S. energy industry was licking its wounds when oil recovered to the $60 level in April. Now, with the price of a barrel back in the $40s, the industry mood is dark, with an outlook for lower oil prices well into next year, meaning more shelved projects, deeper cost cuts and tighter-than-expected funding.

Funding is the life blood of U.S. energy supply, as it provides cash flow for an industry that needs to make capital expenditures in order to make money. A cutback in funding could mean less drilling, which is bullish for the price of oil, but negative for companies seeking to generate cash flow.

That makes the price of oil the wild card—and all the more important as fall approaches. October is when bank lenders perform a biannual review of the loans and revolving credit they make available to exploration and production companies, particularly those in the high-yield space. But because of the sharp drop in crude prices and weak outlook, banks are looking more broadly at their exposure across the industry. And for a small universe of the riskiest names, credit lines could be reduced or cutoff.

"We're in a new regulatory world for banks. They have less flexibility to be forgiving, less ability to be flexible, so producers are going to feel the financial pressures. The majors, with their cutbacks in investments, are girding for a period of lower prices, not necessarily in the $40s, but they're preparing for a more bearish outlook for oil," said Daniel Yergin, vice chairman of IHS. "Coming out of the second quarter earnings, the outlook is more bearish at least into 2016."

Daniel Pickering, co–president of Tudor, Pickering, Holt and Co., said he does not expect the industry to take a big hit in terms of borrowing ability this October, but the weaker companies could feel the pinch.

"The combination of the low prices and debt, that can be a tsunami. Debt in and of itself is not that big a deal if the price is mediocre. It's a much bigger deal if the price is bad, and a much bigger deal if the price is bad for a long time," he said. "If it goes to $30 and is sitting at $30 in October, that could be very meaningful. Oil at $45 is pretty meaningful. Oil at $60 is not that meaningful."

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Pickering said that as far as oil production goes, the funding cutback this fall should affect only a trickle of U.S. output. The next review, in April, could be much more impactful, experts say.

The drop in oil has slammed companies from Exxon to the smaller names in the high yield space. None have been spared the pain of a sharp reversal in crude, and majors like Royal Dutch Shell and Chevron are putting aside future investment and shaving costs. Chevron has frozen its dividend, and Shell, reporting lower earnings, said last month it was cutting back investment and laying off 6,500 workers.

The oil sector has been punished in the markets, with the biggest names, represented by the S&P energy sector, down almost 30 percent in the past year. According to UBS, the earnings of upstream energy names in the sector were down 74 percent in the second quarter, reflecting the dramatic reduction in energy commodity prices.

But some smaller companies that are heavily dependent on leverage, such as MidStates Petroleum. have seen even more dramatic declines in the market. MidStates' stock fell from the $70s last summer to under $3, and its debt was recently trading at less than 40 cents on the dollar.

The majority of borrowing in the oil patch has been in the corporate debt market. While there are plenty of investment-grade companies, E&P companies comprise about 7 percent of the high-yield debt market. About 41 percent of that is distressed, according to Michael Contopoulos, head of high-yield strategy at Bank of America Merrill Lynch. If the price of oil remains at current low levels, defaults could go from a current pace of 10 percent in the energy sector to 20 percent, he said.

Fadel Gheit, senior energy analyst at Oppenheimer, said he's watched the outlook from companies become more negative this earnings season, and the bank reviews could be important.

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"Some people dismiss it, but I think it's an important inflection point," said Gheit. "Banks sit down with their customers and reevaluate their positions. Oil companies borrow, and the collateral is the reserves in the ground. Last year, the oil prices averaged $94 so when investors and banks sit around and say this company borrowed $2 billion, that was fine last year…. But then the bad news started trickling in. Now it's an avalanche of bad news. They are borrowing money to stay in business. They are funding their dividends with additional debt."

The rebound in oil prices this spring brought investors back into energy equities and the high-yield energy space. But since oil tanked again, and with the prospect of Iran bringing more oil onto the already oversupplied market, the view on oil prices has become more bearish. West Texas Intermediate is down more than 16 percent in just the past month.

"Now people are resetting expectations as far as the earnings power and viability of these companies, given the view that oil prices will be lower for longer," Contopoulos said.

For some of the smaller, riskier credits, funding may not be available in traditional markets, and they will spend much more to borrow if they find it elsewhere. Some who were coming against bank borrowing limits dipped into the capital markets, taking on new debt. There was also a rush of equities issuance across the industry earlier in the year, as companies worked to shore up capital.

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SandRidge Energy is one of those that tapped the debt market. Citigroup analysts, in a recent report, noted that they rate the company's debt overweight, saying SandRidge proactively raised secured debt to fund the 2016/2017 cap ex needs, reducing the risk of a bank borrowing base decrease.

"I think the industry is bifurcating. There are very good balance sheets where reserve-based lending isn't a critical component of what they're doing. The larger E&Ps—Anadarko, Devon, Apache, Noble Energy, EOG Resources. Those companies have higher credit ratings. They have access to the bond market," said Pickering. "Those guys are the top tier … the bottom tier, which are companies that are highly leveraged, they may have debt coming due quickly. Bond debt or what not. Those are companies that are shut out of broader credit markets."

Pickering said the banks will get increasingly nervous the longer the low prices prevail. "The lower tier, they're already in a world of hurt. Banks are going to be much more focused on them," he said. "… As the bank redeterminations happen, if the revolving credit lines get squeezed, a company that was reinvesting in drilling wells may not be able to do that…. It can create a challenging cycle."

While another sharp drop in the oil price would certainly limit industry borrowing, Citigroup's Edward Morse said an increase in bankruptcies among U.S. drillers would be bullish for oil. That in turn would help the industry more broadly by reducing output. There have been relatively few bankruptcies so far.

"A bullish sign would be not only a downturn in drilling activity, but also an increase in the rate of bankruptcy and other things. We think the (bank) redetermination in October is going to be a non-spectacular event. The redetermination in April will be a more spectacular event," if oil prices remain low, said Morse, who is global head of commodities research.

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The oil price is the bottom line for the industry when it comes to borrowing and if prices remain low, borrowing would be much tighter during the next bank review period in April. That could force bankruptcies, asset sales and mergers, Morse said.

"If nothing happens between now and October, there will be a lot more angst," Pickering said. "The distressed asset buyer and the private equity guys will be licking their lips to do some deals.... There's been a lot of money raised for energy private equity in the last 18 months."

Industry officials have said the tens of billions of dollars in private-equity funding sitting in the wings could in some ways help prolong the downturn in oil prices, as the availability of capital could very well help keep the industry drilling. But investors also look for stability, and volatile oil prices, like the recent drop from $60 into the mid-$40s, keeps capital sidelined.

"Where's there's lots of volatility, it's hard to act," said Pickering. "If we stay at $45 for a few months ... if nothing changes, things are going to get more active. If it goes down further, the worse it gets, the more nervous people will get, and the more catalysts there will be for companies to take action."

Yergin said the success of the drillers, their use of new technology and ability to extract more oil than ever, has in some ways hurt them more as prices fell.

Basically, the traditional shakeout in the market has not occurred. The self-correcting mechanism of less production did not kick in, while there had been expectations the U.S. industry would ultimately cut back output, instead of increasing it this year.

"Now resilient production is a problem for these companies...We think that to rebalance the market, U.S. production would have to fall by 600,000 barrels a day. With these financial pressures at this price range, it's more likely production, unlike in the first half of the year, would fall rather than increase," Yergin said.

Oil prices have been a moving target for Wall Street forecasters, and many now see a lower price than they forecast even several weeks ago. Yergin said unknowns for the price are the state of Chinese demand, as well as timing on Iran's return to the market.

"Certainly later in 2016, 2017, you'll see oil prices increase, higher prices than what we're seeing now. There's still going to be the winter and spring period. Demand goes down in the spring. I guess you could say already the prices we're seeing today reflect not only the market where it is, but also concerns about the first half of 2016," he said.

The oil market, meanwhile, is watching the fallout on the industry.

"I think everybody thought they were going to implode by now," said John Kilduff of Again Capital. "They haven't. They have amazing staying power. They're survivors. Is the day or reckoning in October or is the day of reckoning in April?"

Oil analysts have keyed in on borrowing and the October redetermination because they are trying to get a handle on how much the U.S. industry can produce and whether it is poised to cut back. While production increased about 600,000 barrels a day this year, it has stagnated for the past couple of months at a level of about 9.4 million barrels a day despite the shutdown of more than half the U.S. rigs.

The rapid growth in the U.S. industry has made it a swing producer of sorts, but instead of acting as a producer like Saudi Arabia with the government's hand on the switch, the U.S. industry's dozens of companies control the flow and they rely on capital.

"The U.S. is a swing producer. It just doesn't swing as much on the downside or upside as Saudi Arabia," said Morse.

As for Saudi Arabia, it ramped up its own production, after getting OPEC to agree to allow the market to set prices late last year. Saudi Arabia is now producing a record 10.5 million barrels a day. That has added pressure to the market, as has increased production from Iraq.

Gheit also says the U.S. industry's resilience has been surprising, and it has become more efficient, but the industry is still sitting on a high debt load.

"At the end of the day, borrowing is borrowing. Having this huge amount of debt is never, never good," Gheit said. "Especially, you see what the companies are doing right now. The oil companies are running on cash flow, not on earnings…. So all companies that I know of are not living within their means…. How long can that last?"

"Every company I know of, including Chevron, Exxon, BP, Apache, Anadarko, every company, you name it. They are all exceeding their cash flow. That's not sustainable. Something's got to give," he said. Gheit said the industry will have to look harder for cost cuts after already trimming spending, shutting down projects, laying off staff and trimming dividends.