The oil price collapse has hit North American companies particularly hard as of late. And many of them are going to be left out in the financial cold as their hedging strategies begin to expire.
Oil and gas producers typically hedge their production by locking in higher prices for future deliveries of crude oil, which is exactly what many U.S. firms did. This allowed for a certain degree of protection from the volatile oil price collapse, partially shielding companies from oil prices which have fallen by more than 50% since this time last year.
But most were not able to completely hedge their production from plummeting oil production, and revenue streams began dipping violently as current prices reduce the bottom line of oil producers. However, the majority of oil and gas companies have been able to cut operating expenses, take out loans, and implement the aforementioned hedging strategies to keep their head above water. Excluding some tragedies, most have not missed debt payments or been forced to declare bankruptcy.
Until now, that is.
The game of financial hot-potato being played by oil and gas companies is reaching a critical point. And many of them won’t be able to last much longer.
With the oil price forecast remaining abysmal and the threat of a Chinese economic collapse casting a long shadow, there’s little hope to bank on in lenders’ markets. A growing number of oil and gas companies will see their hedging strategies expire as oil stays lower for longer.
The result will be full exposure to rock-bottom crude oil prices, and that’s when the real trouble will begin.
Many smaller companies were cautious in 2014, locking in higher-priced crude oil futures for most of 2015. Their small size and lack of vertical integration across the entire oil value chain meant that they couldn’t rely on refining operations to offset losses in downstream production.
In fact, approximately 20% of North American West Texas Intermediate (WTI) production is still hedged at a median price level of $87.51. (Source: Houston Chronicle, last accessed September 3, 2015.) The trend is more prevalent the smaller the operation. Estimates indicate that smaller oil and gas producers had nearly half of their product well-hedged at an average level of $89.86. (Source: IHS, last accessed September 3, 2015.)
The results were good balance sheets, and a good amount of insulation from oil’s current woes.
But this will change, and oil producers are now left with little maneuvering room because new hedges will be linked to current oil prices in the mid-$40.00s per barrel.
Add to the mix crude oil’s record volatility in the past week and you get the picture: there are a lot of people losing sleep over this.
But it gets worse.
September and April are usually the months in which credit redeterminations take place, where financial institutions re-examine and recalculate loans to oil and gas producers. As the oil price clings stubbornly to six-year lows, and crude prices are the primary determinant of a firm’s ability to service debt, many energy companies which have been able to keep the wolf from the door will find themselves unable to refinance their operations.
In an industry where a fraction of a dollar difference in the price of oil now translates to millions in profit or loss for the producer, many companies are going to find themselves at the end of their rope.
Last April was a different time, as crude oil had snapped out of its March dip and was surging upward like a raging bull. But no financial institution can now even semi-safely bank on the energy sector, with the oil price forecast remaining negative.
Even for those companies that will be able to secure new lines of credit, the amount available will be 10-15% lower on average, which will effectively remove billions of dollars of badly-needed credit from the oil sector. (Source: Bloomberg, last accessed September 3, 2015.)
Again, it gets worse.
Even if banks were willing to keep the cash flowing, new financial regulations are putting pressure on them to be more conservative towards energy sector loans. (Source: Financial Times, last accessed September 3, 2015.) Loans will be moved to “workout groups,” whose primary goal is to recover the maximum of the amount owing to the bank, without regard to the debtor.
Measures intended to guard against contagion spreading to lenders are working against oil and gas producers.
Brace yourselves for more financial market pain, because it’s not over yet.