More U.S. oil and gas companies could come under financial distress in the coming months as crucial hedging protection begins to expire.
Many companies had locked in high prices for their oil sales last year, allowing them a degree of protection as oil prices collapsed precipitously over the second half of 2014. Few, if any, hedged all of their production though, so revenues declined along with the oil price. Still, with some protection, the vast majority of companies (aside from a tragic handful) have not missed debt payments and have stayed out of bankruptcy.
That could become an increasingly tricky feat to pull off. As time passes, more and more hedges are expiring, leaving oil companies fully exposed to the painfully low oil price environment. “A lot of these smaller guys who had bad balance sheets have pretty good hedge books through full-year 2015,” Andrew Byrne, an analyst with IHS, told the Houston Chronicle. “You can't say that about 2016.”
In fact, about one-fifth of North American production is hedged at a median price of $87.51 per barrel. Smaller companies rely much more heavily upon hedging as they are more vulnerable to price swings and are not diversified with downstream assets. Across the industry, IHS estimates that smaller companies had about half of their production hedged at a median oil price of $89.86 per barrel in 2015.
But as those positions expire, any new hedges will be linked to current oil prices, which are now trading around $45 per barrel (although prices are fluctuating with great intensity and ferocity these days).
More worrying for the oil and gas companies that are struggling to keep their lights on is the forthcoming credit redeterminations, which typically take place in April and September. Banks recalculate credit lines for drillers, using oil prices as a key determinant of an individual company’s viability. With oil prices bouncing around near six-year lows, more companies will find themselves on the wrong side of that equation.
Banks were more lenient in April when oil prices were a bit higher and many analysts expected prices to rise. This time around the pain is mounting and there will be a lot less leeway. Somewhere around 10 to 15 percent credit offered to drillers could be cut back on average, a move that could slash $15 billion in credit capacity, according to CreditSights Inc.
With other financial avenues cut off, indebted drillers could be left with no way out. “Nobody is in good shape with oil at $39,” CreditSights Inc. analyst Brian Gibbons told Bloomberg in an interview. “Most energy companies are shut out of the debt markets. There are few companies that can get a deal done right now.”
Even if banks wanted to lend to struggling oil and gas drillers, or were open to the idea of restructuring existing loans, there is another looming problem for the industry: the possibility of increased regulatory pressure on the banks exposed to energy loans. According to the FT, banking regulators are pushing banks to take a more conservative approach to their energy loans. If loans to indebted oil companies appear at risk, regulators want banks to move their loans into “workout” groups, which are run by “troubled asset specialists” with the mission to recover as much of the loans as possible.
The procedure is intended to guard against bank failures, but in effect, it could force distressed oil and gas companies to prematurely sell off assets and/or lose access to their financing. “Workout’s job is to achieve the maximum recovery on the loan,” Bill White, Chairman of Houston branch of investment bank Lazard, told the FT. “The banking relationship with the borrower is not part of the agenda of the workout group, whereas the relationship banker will appreciate the fact this is a cyclical period.”
“One consequence of this would be that people are forced to sell assets in a market which many of us — including me — believe is at the bottom of the commodity price cycle,” he added.
But it is not as if regulators are off base. In Canada, the largest banks are reporting higher impairment charges on their portfolios as oil prices stay low. For example, TD Bank saw its impairment charges rise by two-thirds this quarter compared to the second. CIBC, RBC, and the Bank of Montreal all reported a sharp increase in impairment charges as well. Given the growing losses for energy lenders, the oil and gas industry could see access to credit much harder to come by in the weeks and months ahead.
By Nick Cunningham of Oilprice.com
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