Oil and Gas Debt Crisis: Quick Onset but No Quick Fixes

While the general population enjoys lower gasoline prices at the pump, the impact to the oil and gas industry in this country, and its implications for our broader economy, is likely much worse than the public realizes.
U.S. oil and gas debt has surpassed the $100 billion mark and is quickly approaching $200 billion. While many in industry anticipated future impacts from overcapacity and inadequate infrastructure, very few expected this most recent price collapse to happen so soon and to progress so quickly. The fundamentals for industry were very different six weeks ago and now interested parties are scrambling to reposition themselves.

In the U.S., a major factor precipitating this crisis are the steep decline curves typically associated with unconventional plays. A lot of drilling and significant increases in oil production was occurring over a short period of time. This surge in drilling, which is very capital intensive, resulted in massive demand on the service sector. Fleets of equipment were expanded, labor forces ramped up, and unprecedented economic growth was spreading to small towns and corners of America. Low commodity prices, of course, cannot sustain this.

Unfortunately, much of problem lies in our infrastructure so there is no short-term solution.

On the natural gas side, we do not yet have the ability to transport and export the volumes of gas being produced. The relationship between supply and demand are fairly predictable, but once you have reached capacity you see rapid declines in natural gas prices and we currently have a glut.

The same is true of oil; we don’t have the infrastructure to transport and store all the oil coming out of the newly developed shale plays. Nor do we have the legal authority to export much crude.

The manufacturers of field equipment are already taking a bit hit. Service companies are not ordering equipment right now and it will likely come to a halt.

During the second and third quarter of this year, the service companies, which drill and maintain oil fields, will have severe cash flow problems that will become apparent to the rest of the world. The exploration and production companies that utilize their service are requiring 20-30 percent discounts, which will tighten service companies’ working capital. Service companies are getting 30 percent less on pricing; their volumes are declining; and their receivables are likely getting stretched out another 20-40 days. That’s a difficult combination to absorb.

For the upstream companies, the short-term impact largely depends on whether, and by how much, they are hedged. If they are sufficiently hedged, they have some headway. In simplest terms, they will continue to benefit from yesterday’s oil prices for anywhere from six months to a year. Those that are not hedged will not have those protections in place. Those companies already having problems are completely exposed to commodity prices and are going to have a tough time. They may have no choice but to shut in production and may end up losing leases, which creates a difficult situation to restructure.

The most valuable piece of information out there right now is how much of the 2015 production is hedged. When I speak to service companies I tell them one of the most important things when evaluating credit to the exploration companies right now is to determine how much of the production is hedged. That will directly impact the exploration company’s ability to pay its vendors, at least for some period of time.

This is also good advice for debt investors. Debt investors should look at how much a company is hedging before considering purchase.

I would encourage today’s debt investor in the energy space to evaluate these situations as an equity investment and be mindful of operational issues. Many of these situations will actually be taking on equity risk. Service company economics are driven by fleet utilization and firms will not attract investors if they cannot keep their equipment utilized. An investor does not want to put capital into a service company only to see the equipment sitting idle and deteriorating. A debt investor today needs to have a well-thought-out strategy on how they are going to equitize their debt and take the actions needed to make their investments profitable.

In time, we will likely see liquidation and consolidation on a large scale. There is a large amount of capacity in the market right now because so much capital was invested to service a growing demand for drilling. This is now slowing down or coming to a halt. Many equipment companies will need to either liquidate or consolidate. Service companies will need to right size their equipment inventory, as the existing supply of service companies and equipment is far greater than the demand for drilling.