Just when revenues are hitting decade old lows, the cost of financing for your favourite oil company is going up…

The oil industry is all about boom and bust.  We live with inherently long investment cycles and have global macro-cycles layered on top.   I have speculated about the ability (or rather, inability) of the financial markets to respond to a second coming of the US shale industry in a previous post.  What is significant for all players is that the cost of capital is increasing across the board.

Typically companies finance themselves with a combination of debt and equity.   We may hear all sorts of nomenclature with term loans, revolvers, RBLs, mezzanine, bonds, kickers, warrants etc, but it is all either debt or equity in some form.  The average cost of financing a company can be simplified to the Weighted Average Cost of Capital (WACC) – where the cost of each component is weighted by its relative proportion in the mix:

WACC =   (%debt  *  cost of debt)  +  (%equity  *  cost of equity)

Importantly the %equity term should be thought of as 1-%debt, because when debt is not available, equity has to make up the delta.  The obvious case of this is exploration companies who have no access to debt are 100% equity funded. 

Pre-2008 financial crash, debt was cheap and abundant due to the recycling of sub-prime money into the system.  In the post-2008 crisis days debt has been even cheaper and even more abundant thanks to QE.   It is quite easy to correlate both the US shale-oil boom and a world-wide string of exploration failures to this easy money.  If money is so cheap that it has almost no value you can go chasing dreams…  with hindsight, some wildly optimistic exploration wells were drilled (unsuccessfully) in the last 5 years.

In the down-swing, banks panic and reduce their lending – indeed some close their O&G desks completely. Thus debt becomes more scarce and equity has to be brought in to plug the gap.  Of course a company with less debt capacity is inherently more risky, and more needy, so the additional equity comes at a price, and that price is the dilution of existing equity.   Oh and if the sector is out of favour, the cost of equity (you have to offer a bigger discount to attract the equity so that it can aspire to risk-weighted returns, since it is competing with other sectors globally)…. goes even higher.  

So for the WACC, the % of debt decreases (and its cost increases, although this is a second order variable), whilst the % equity increases, and the cost of equity increases.  Equity is always more expensive than debt, and now it is much more expensive, so the whole WACC is up by a lot.

So when you next do a DCF analysis on a company, stop and ask yourself:

  • Is the the discount rate you are using (10%, 12%, 15%.. ?) is really a reflection of the real risk/cost built into that company’s finances?
  • Is it right to use the same discount rate at the top of the cycle as at the bottom?  (Answer: no.)  
  • If you are comparing two companies – their balance sheets should, to a large extent, determine the discount rate you should apply, and it may well not be the same, even if they have similar assets/geographies.  

The value of an unfunded business plan could arguably tend towards zero… or the at the very minimum the analysis should be done on a per-share basis taking into account the increased level of equity now needed to fund that business plan – hence dropping the per-share value of that plan because of the new dilution dynamics!