No conversation about the first quarter of the year would be complete without us touching on energy prices. But instead of looking at just a three-month window of the first quarter of 2016, I think we have to step back and look at the market in a broader context.
After hovering around $100 per barrel for nearly four years, the price of crude oil fell – a lot – and is now hovering in the low $40. The go-to answer that most experts and non-experts use to explain this wild drop has most often been a massive oversupply. The astute ones will cite that this was driven by American ingenuity.
Now it’s easy to point to oversupply and quit looking further. After all, there has undoubtedly been a remarkable boom in U.S. production following several impressive technological advancements, and massive investment inflows into the space. In just the last few years, Americans have learned to unlock “unconventional” oil and gas assets using horizontal drilling, fracking and other enhanced recovery techniques. But is there more going on?
First of all, the fall in the price of oil has not had quite the rosy impact on the U.S. economy that many were expecting. Oil is an expensive input cost for most business sectors, including the American family, and after a fall in prices, we should expect to see a boost to household incomes and corporate profits globally. But this has not quite materialized. Why? If it were just a matter of oversupply, we’d see a relatively near-term reversal of fortunes. Rig counts in the U.S. are certainly falling, indicating that new production is on the lam. (Admittedly, OPEC is cruising full speed ahead, so global production is likely not slowing at the same rate). So is there something else pressuring the industry?
What helps shed more light on this story is the high levels of debt the industry took on, and is still working to digest, during the high price period between 2010 and 2014. According to the Bank for International Settlements, the debt borne by the oil and gas sector has increased two and a half times, from roughly $1 trillion in 2006 to around $2.5 trillion in 2014. Most of that was debt underwritten with a significantly higher oil price in mind.
But who was taking on this debt? The largest and “safest” major producers remained pretty disciplined, according to the chart below. They kept a median debt-to-asset ratio of less than 16% in 2006 and 2013. The smaller and middle-sized companies, conversely, nearly doubled their debt-to-asset ratios to a median of nearly 32%. Emerging Market Economies’ (EMEs) state-owned oil and gas firms also took on more debt. This increased debt load in America is in part a result of the accommodative monetary policy by the Fed, which made borrowing easy for these smaller companies.
And here’s why the high debt loads of smaller companies makes a big impact on the whole industry. The price of oil determines the value of the underlying assets that collateralize that debt. And a heavily indebted industry suggests that what should have been a short-term correction sparked a more prolonged industry-wide selloff. Lower prices reduce profits thus increasing the risk of default and raises borrowing costs. So it is no surprise that these elevated debt levels in high energy price periods allow for a flurry of oil and gas drilling activity. Investors and industry executives alike tend to forget that leverage works both ways.
So when does the pain stop?
I would argue that there is still a lot of underwater debt that has yet to be digested in the oil and gas industry globally. There are going to be more shut downs, more sell offs, and for the lender, more write offs - with the lower-quality junk bond market leading the way. For the banks, this will mean less lending to good companies to get operations rolling, setting the stage for a sharp price rebound when the turn does finally occur. And this ignores OPEC, the principle actors of which seem preoccupied with playing political chess games with one another.
So while the pain is not yet over, we are already seeing American producers taking steps to correct the oversupply problem.
For examples of how quickly American producers have responded, look no further than the falling rig count. They’re down about 75% since late 2014.
As the American system attempts to rebalance, all eyes have been on the OPEC member states. They’ve been unable to gain consensus, and despite what CNN may say, I think the group may now be less impactful than they are perceived.
In general, OPEC member countries are nearly all facing heavy production decline rates. Many of them, (referencing the debt chart above) have taken on more debt than they had in 2006, so they are facing the same balance sheet pressure as many American companies. However, these are countries for which the national income is largely dependent on revenue from oil. The lower prices mean they are getting squeezed at the margin, and many of them are trying to make it up on volume. As in, reducing production may not even be an option.
In short, there are at least three facets to consider in the current oil market.
1) North American inventory levels remain high following several years of unprecedented investment in development of American oil and gas fields. However the production rates are slowing, and a collapse in the rig utilization count shows production may be slow to re-start in the near future.
2) OPEC’s continual threats to slow production in order to boost global prices are a moot point. These countries are dependent on income from oil and are not able to boost production appreciably in the mid-term anyway. Most of these countries have taken on higher debt loads themselves and are struggling to service them, so a slowdown may not be achievable either.
3) American oil and gas companies are also grappling with their own high debt loads. We expect more write offs to occur in 2016 as the lenders seek to revalue their outstanding credit to struggling oil and gas producers.
Bear markets are the authors of bull markets and I believe the shakeout in the industry is still not entirely over.
But will prices remain low forever? Doubtful.
Nobody cared about precious metal markets just six months ago and look where we are today in that space. A day will come again where investors start clamoring for energy stocks.
If you have any questions about this article, please contact your Sprott Global advisor, or the author, Eric Angeli at EAngeli@sprottglobal.com or 800-477-7853.
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