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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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U.S Drillers’ Operating Losses Could Surge In 2016

U.S Drillers’ Operating Losses Could Surge In 2016

What do you do when all of the low hanging fruit is gone? That question is one that oil producers are increasingly facing as they confront an oil price slump that is now more than a year old and shows no serious signs of abating. With oil prices having fallen by nearly half over the last sixteen months, it is little wonder that oil companies found their balance sheets under pressure. From Exxon to Continental all oil companies have faced problems in maintaining their capital spending and more importantly, their profitability. In light of that, it is little wonder that oil companies pulled every lever they could to survive.

The vast majority of oil companies have seen their profits fall markedly in the last year, and most companies have turned to the same three tools in order to cope with falling prices. Related: Oil Price Rebound Not Imminent, But Underway

First of all, companies have been relying on production growth. Shale producers especially have done all they can to keep production as high as possible. The idea has been to offset the falling price per barrel with more barrels of output. Some firms, like Devon Energy, have been exceptionally successful with this strategy. The problem is that production growth is not sustainable for shale firms in the absence of large amounts of capital spending, which these firms cannot sustain at this point. The declining production curves are simply too great for oil companies to keep the oil flowing without significant new investment. Thus investors should be prepared to see production fall in 2016.

Secondly, cost cuts are also playing a big role at oil companies in sustaining profits. Oil companies in general are “sharpening their pencils” on cost cuts according to analysts. The supply chain crimp on prices across the entire oil vertical has been severe. From Haliburton to Frank’s International, every oilfield supplier has felt the pinch. This has motivated the supply chain to be more efficient in providing services and has let oil companies wring additional savings out of their businesses’. Related: Will Iran Double Down On Downstream When Sanctions Are Lifted?

These double-digit savings have helped oil companies considerably in maintaining the bottom line, but it is starting to look like that trend may be waning. From Baker Hughes to mom & pop operations, the supply chain simply cannot do much more to help producers. That bodes ill for 2016 profits at oil producers.

Finally, and even more important than production growth, oil producers were as a group fortunate and wise enough to be significantly hedged against the fall in oil prices over the last year. For much of 2015, oil prices hedges have helped keep oil companies afloat and led to sizeable hedging gains. Related: Besides Europe, Saudis To Capture Russian Market Share In China

The problem is that very few companies hedge out for more than one or two years. As a result, these existing hedges are now starting to roll over which is leading some to predict hard times for the industry ahead. Oil companies now face a choice of hedging production at much lower levels per barrel, or of selling production at spot prices and hoping for a rebound.

Given hedges have arguably been the biggest source of economic strength for various oil companies, it is likely that many firms will be facing severe operating losses next year.

That in turn could finally motivate sellers of oil assets enough to narrow the spread between bids and asks on assets which are on the block. More importantly, as those wells continue to decline in output and less capex goes into maintaining them, national oil production could finally start to stagnate or even fall. And that would finally set the stage for a limited rebound in prices. In this case, oil companies do not need to be “faster” than the “oil price bear” they just need to be “faster” than the slower companies in the industry.

By Michael McDonald of Oilprice.com

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  • anon on November 25 2015 said:
    -Operating "Losses", could- ... Don't you people have any proofreaders or editors on staff? Try learning the difference between 'loses' and 'losses' for a start.

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