Bleak Midwinter view of 1H 2016

Is this the winter of our discontent?  

Probably not; times are tough in the O&G sector – but this being the season of good cheer, lets look at how much worse it might get in 1H 2016.

Interest base rates

Later today the Fed is expected to raise interest rates – the first time since mid 2006.  I can barely recall 2006, so nearly a decade has gone by in the era of cheap money.  This isn’t all about to change overnight; the expectation is 25bps, but it is  one variable amongst many that will impact borrowers.  O&G companies are typically big borrowers…  In good times a few basis-points might go unnoticed, in 2016, these will contribute to pain for those already stretched.

RBL – redeterminations and PUDs

The lending banks are going through the 5 stages of Grief; denial, anger, bargaining, depression and acceptance.  

Summer 2015 was denial, oil had had its dead-cat bounce and borrowing-bases were deemed to be fit for purpose.  

Fall 2015 was anger, a fair bit of noise about redeterminations and certain banks downsizing RBL teams, but overall it was noise without any serious downgrades of borrowing bases as banks chose not to crystalze the downswing in oil prices.  

Spring 2016 – looks like bargaining will be a good analogy, as banks and borrowers get down to real negotiations about covenants and redeterminations.   Depression will probably follow rapidly.

To add spice to this mix, there is talk that US regulators are very concerned that the extensive lending to the O&G sector could represent a systemic risk akin to the sub-prime.  Clearly it is different, but the net result may be a restriction on PUD lending – so that RBL goes back to PDP lending (with a haircut).  The alternate will be for banks to increase their Tier 1 capital to offset the ‘risky’ PUD lending.   Forget 2P lending completely.   This is likely to ripple through to European lending, as the US banks won’t be in the bigger syndicates, or worse, the European banks will follow suit.

Junk Bonds

Significantly more O&G lending has come from the Junk Bond market than from commercial banks in the US.  Some 14% of US Junk bonds are in the O&G sector.   By definition, “junk” bonds are issued by borrowers who have less than stellar balance sheet; these then get stretched by falling commodity prices, and the bond holders get very nervous.  A nervous market begets a herd mentality as no one wants to be the mug standing at the end of the game of musical chairs…

I see two related consequences:

1) Bond holders will take losses and O&G companies will not be able to issue bonds for several years – until investors with famously short memories come back into the market, and

2) Losses on debt today will not be forgotten immediately, so as and when oil prices rise again – US shale producers who have run huge negative cash-flow companies funded by cheap debt and cheap equity – will not have access to these same sources (or volumes) of funding.  At least the majority of them won’t.  Some of the top tier ones will, but this will  not be enough to impact world markets.

Hedges

Those who did hedge will see these rolling off with little incentive to replace with hedges at today’s prices and implied volatility.   Again, the bottom-line will start to bleed.

Equity

It is true that there is a lot of equity waiting for ‘distressed’ opportunities in the O&G sector, especially in the US.  Clearly there will be opportunities, and one can only hope that rational heads will prevail, with capital not going to support basket-case producers.  As the US tight oil (and gas) plays become better known, it is clear that there are massive differences between sweet-spots and the rest.  Good acreage should end up with well-run companies, and badly run companies and bad acreage should get left by the wayside.

Meanwhile the equity of O&G companies is going only one way, whilst everyone bets against the sector, or in many ways worse, just ignores it…

Oil Price

And then there is the oil price, which now has no fear of any supply disruption.   This seems wrong on many levels – whilst there is a clear glut of oil, it is salient to see that the world’s three biggest producers (US, Russia and Saudi Arabia) are all at or near their historical peak production levels.   Yes Iran is a wild-card as is Iraq, but its not as if any of the big boys have significant spare capacity in the event of other supply disruptions.   

The fact this seems wrong, probably means that it will continue its merry course down for some time to come, until we are all ‘surprised’ by a sharp correction.

Oh, and don’t forget the warm-winter in the US and Europe – removing demand just when we “need” higher demand to help reduce the huge inventories being built.

There will be blood…

So for my 1H2016 prediction – I see low oil prices combining with hedge positions rolling.off and restrictions on borrowings causing serious losses for investors in equity and bonds.   Companies will continue to cut Opex and Capex, and indeed in many areas will drop to “survival” or “hibernation” mode.  M&A ought to surge, but ‘ought’ and ‘will’ are still quite far apart.  

Whilst the outlook is bleak for E&P companies in the short term, I am also of the view that this continued culling of investment in the sector will lead to medium term supply shortage and consequent price increases.   The ability of US oil shale to jump back in and dampen any increase (by increasing supply) in a rapid fashion is being eroded every day that the oil price stays low in the current environment, with funding for “Oil Shale 2.0” being the big known unknown.

I’ll save my 10-15 year view for another post, but in the meantime and with respect to short-medium terms view:

Hunker down, do what ever is needed to survive and wait for the (almost) inevitable upturn.