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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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Why Are Bankrupt Oil Companies Still Pumping?

A central tenet in the thesis by analysts about the oil markets rebalancing has been that as prices declined, oil companies would be forced into bankruptcy. That in turn would lead to declining production, and eventually a rebalancing of supply and demand in the market, followed by higher prices. That process is already taking longer than many expected, and it looks like more time is needed. That additional time to balance the market is being driven by an unexpected factor; bankrupt oil companies are still pumping.

As oil prices have declined, the number of bankruptcies and distressed oil majors has quickly risen into the dozens. In fact, a recent Reuters analysis suggests little effect on production from when companies enter bankruptcy. Reuters cited Magnum Hunter as a primary example of this reality. Related: Oil Price Rally Unwinds As Strike In Kuwait Ends

While Magnum Hunter filed for bankruptcy in December 2014, the firm has scrambled even in Chapter 11 to keep its oil flowing, resulting in O&G production rising by roughly one-third between mid-2014 and late 2015. The firm has used the protection bankruptcy courts to help stave off creditors while keeping the pumps flowing full tilt. Nearly all of Magnum Hunter’s 3000 wells are still producing crude, and that makes sense for several reasons.

First, daily costs for operating wells remain well below current spot prices. While drilling new wells is not economical, it is perfectly logical to keep exploiting existing wells. Fracked wells usually start to see a significant decline in production after about two years of operations. So eventually Magnum Hunter and other companies will see their production fall, but two years can be a very long time to pump. Related: Lithium War Heats Up After Epic Launch Of Tesla Model 3

Second, creditors want to extract maximum value from the company and the best way to do that in the current environment is to keep the oil flowing. Bid-ask spreads on oil assets for sale are simply too wide for most companies to be interested in selling assets while in Chapter 11. Instead, creditors maximize the present value of their assets by continuing to pump oil. This oil can either be stored leading to a large risk free profit, or it can be sold on the spot market. Either way, Magnum Hunter and other bankrupt producers are acting in the best interests of their creditors by continuing to pump. Unfortunately, those actions are not in the best interests of the broader industry or energy sector stock investors.

Third, management at bankrupt producers also have little reason to do anything other than keep the crude flowing. In the current energy market, getting a job is very difficult, especially for top managers coming from a bankrupt producer. As a result, managers rationally want to make sure they stay useful in Chapter 11 and that means trying to convince creditors to keep the company operating rather than converting to a Chapter 7 liquidation. Not all O&G firms should be kept operating – some firms are better off being liquidated – but creditors often lack the necessary industry expertise to be able to distinguish between firms that have a future after emerging from Chapter 11, and those that don’t and are better off in a Chapter 7 sale. And again, management has very little incentive to put themselves out of a job by recommending Chapter 7. Related: Oil Prices Up On Weaker Dollar, Declining Production

On the whole then, while the oil markets are slowly making progress in rebalancing, the process is slower than most investors would like. Bankruptcy alone cannot rebalance the oil markets. Instead, natural well depletion and a lack of new investment are the driving forces that are reducing production over time. Those forces will continue in the future, but for now investors will just have to be patient and not get ahead of themselves.

By Michael McDonald of Oilprice.com

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  • mchentrp on April 21 2016 said:
    Chapter 11 debtor in possession. Cram down all that highly leveraged debt to ten cents on the dollar. Keep the cash flowing as much as possible to cover post filing contracts. Come out in a year or two in terrific financial position. Sounds like "don't throw me in that briar patch!"

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