Operational Efficiency Size Matters: Surviving a Pricing Downturn
Size Matters: Surviving a Pricing Downturn As crude oil prices have fallen and North American natural gas prices remain weak, hedging will provide some temporary relief for the oil and gas sector. However, limited hedge protection exists beyond 2015. In a representative sample of 44 large, mid-size and small North American exploration and production (E&P) companies, analysis of both their balance sheets and commodity price hedge protections showed that in a downturn, company size matters. In particular, the stronger balance sheets of the large North American E&P companies that IHS evaluated will enable them to withstand lower prices longer than their midsize and small counterparts. This advantage positions the large companies as potential buyers of bargain-priced assets and distressed E&Ps. In comparison, the highly leveraged companies the majority of which are small E&Ps may be forced to take bold moves as low prices take a further toll on their financial health. Many will be obligated to continue producing oil to service interest payments and repay debt, and to remain within their debt covenant requirements. While small companies have the largest hedge position in 2015, few have significant hedge positions in 2016. As a consequence, they could face serious liquidity problems if oil prices remain depressed beyond 2015. Overall fourth-quarter 2014 financial results did not offer true insight into the impact that lower commodity prices have had on company earnings. Strong hedge books buoyed revenues, particularly for the small and midsize E&Ps, who had more than half of total production respectively. This includes hedging of crude oil, natural gas, and natural gas liquids (NGLs). As hedges roll off, particularly in the latter half of 2015 and into 2016, results will be more reflective of the current price environment. Current low futures prices mean that operators are unlikely to be able to lock in new hedging volumes at attractive prices. Those with little or no hedging in place will be highly susceptible to the persistence of low market prices. West Texas Intermediate (WTI) oil prices averaged around $73 per barrel (bbl) during the fourth quarter of 2014, approximately $25/bbl higher than current market prices. Implementing hedges, which protect against further downside to currently unattractive prices, will likely be the only option for adding new hedging.
North American E&P Peer Groups: Percentage of production and implied weighted-average prices, full-year 2015 Company oil production implied price, $/bbl gas production implied price, $/mcf total production Small NA E&P Peer Group 50% $86.43 53% $3.89 47% Midsize NA E&P Peer Group 39% $79.63 39% $3.98 36% Large NA E&P Peer Group 11% $86.05 29% $4.17 19% Total NA E&P Peer Group 19% $83.46 32% $4.10 24% Implied prices assume $50/bbl market oil price and $3/Mcf market natural gas price in 2015. Source: IHS, company filings, investor presentations. The overall universe Collectively, the North American E&Ps that IHS studied have 24% of total 2015 production volumes, including 19% of oil at a weighted average price of $83.46/bbl, and 32% of natural gas at $4.10/Mcf. The small and midsized North American E&P peer groups, categorized by their proved reserve sizes of less than 400 million BOE, and 400 million BOE to 1 billion BOE, respectively, have a significantly greater percentage of production for full-year 2015 than the large E&Ps. For 2015, small and midsize E&P s have 47% and 36%, respectively, of total production compared with the large North American peer group, with proved reserves of greater than 1 billion BOE, which has only 19% of 2015 production ; see Figure 1. North American E&P companies have better hedge protection for gas production compared with oil production in 2015. The group that IHS evaluated has 32% of 2015 gas production, on a productionweighted basis. The weighted average implied price for full-year 2015 is $4.10/Mcf, above the fourth-quarter Henry Hub average price of $3.75/Mcf and the current price of approximately $3/Mcf. Combined, the North American E&P groups for 2016 have only 5% of oil production and 8% of gas production, leaving the group largely exposed to weak prices in the longer term. If low oil prices persist, the upcoming years will be challenging for oil producers, their service providers, and their extended supply chain partners. Long-term investments will be delayed or cancelled, R&D spending will be lower, capex will be slashed, and headcount will be reduced. Companies have announced various measures to cut costs in the wake of the fall in oil prices. Some have slashed spending by reducing rig count and focusing drilling in their most prolific areas. Others have made large cuts to dividends. Under a scenario of a $70/bbl flat oil price, the median debt-to-appraised worth of assets (AWA) ratio for the small and midsize North American E&P peer groups is uncomfortably high at 51% and 37%, respectively, compared with 21% for the large North American E&P peer group. This is based on third-quarter 2014 balance sheet data, the most recently disclosed at the time of publishing this article. In addition to debt-to-awa, IHS used interest coverage ratios and total debt per boe as the barometers for financial health. Using these metrics, the large E&P peer group median third-quarter 2014 interest coverage ratio was 25 times, compared with 10 times and 7 times for the midsize and small-sized companies, respectively. Reported third-quarter numbers included top-cycle commodity prices that have plummeted and in the money hedges that will roll off. The large E&P peer group is still strong if interest coverage is halved, while the midsize group has a less stable 5 times interest coverage ratio, and the small company peer group has a troubling 3.5 times interest coverage ratio total debt-per-boe metrics further confirmed our analysis. If oil prices stay depressed, it is reasonable to expect material write-downs and/or impairment charges to come.
Small North American E&P peer group The weaker balance sheets of the small companies require greater protection from weak commodity prices. The small North American E&Ps have the worst balance sheets and the largest hedge positions in 2015. Few small E&Ps have any significant hedging for 2016, so serious liquidity issues will arise should prices remain depressed beyond 2015. Because of their precarious financial positions, small North American E&P companies cannot afford to weather the storm and wait out low oil prices, like some of their larger peers can do. These conditions put them most at risk of being forced to take more extreme measures, such as slashing spending, laying off staff, selling assets or even pursuing a sale of the company if low oil prices persist. During the first quarter of 2015 we saw a number of E&P s issue common stock in order to pay down debt and strengthen their balance sheet. Since their debt metrics have deteriorated in the current price environment, if commodity prices remain low the risk of violating their debt covenants increases, which will further complicate some of these companies financial conditions. The small North American E&P peer group 52% of fourth-quarter 2014, 47% of 2015, and 16% of 2016 total production, respectively. Broken down, they had 53% of oil production in the fourth-quarter 2014, 50% in 2015, and just 14% in 2016. Those best protected have more than 70% of oil production for 2015. The small E&Ps had 58% of natural gas in the fourth-quarter 2014, 53% in 2015, and 20% in 2016. One of the best companies in this class has more than 77% of 2015 and 75% of 2016 gas production at $3.95/Mcf, about $1/Mcf higher than current market prices. There are a few high-debt companies with a majority of production un. This includes four that have less than 40% of 2015 and 15% of 2016 total volumes. Midsize Peer Group The midsize North American E&Ps are also highly leveraged and have 36% of 2015 total production. The group has 20% of 2016 oil production but just 10% of 2016 total production. The median debt-to-awa for the group is 37%, lower than the small E&P group but still high. The midsize E&Ps had 64% of oil production in the fourth-quarter 2014, 39% in 2015, and 20% in 2016. Several companies have as much as 75% of 2015 oil production. The midsize E&Ps have 57% of natural gas in the fourth-quarter 2014, 39% in 2015, and 3% in 2016. Midsized companies with the highest debt have turned to cost-cutting and asset sales to avoid breaching debt covenants. We expect such cuts will increase if low oil prices persist through 2016. IHS North American E&P debt-to-appraised worth of assets and 2015 total production Percentage of 2015 total production 100% Median: 31% Hedge-protected Small and Lower-debt, AR Higher-debt, 90% Midsize E&Ps more more Robust financials Large HK DNR 80% and Midsize E&Ps NFX LPI ROSE PDC 70% XCO RRC PVA 60% PXD WPX GPOR 50% QEP BBG EQT NBL ECA SGY OAS 40% ARC DVN CXO UPL SD CHK AREX Median: 41% COG SM 30% SWN PWT APC WLL At-risk Small and 20% Midsize E&Ps Lower-debt, EOG CNQ Higher-debt, 10% less APA CRK less OXY XEC HES COP MRO CLR MUR 0% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Debt-to-appraised worth of assets calculated using $70 flat oil price. Source: IHS Debt-to-appraised worth of assets (AWA) ratio Large NA E&P Peer Group Midsize NA E&P Peer Group Small NA E&P Peer Group 2014 IHS
Large E&Ps The large E&Ps have only 19% of 2015 production. The stronger balance sheets of the group, which has a median debt-to-awa of 21%, will enable them to withstand lower prices longer than their smaller counterparts and position them as potential buyers of distressed E&Ps. This group has 11% of 2015 oil production, and is largely un for 2016. As for gas production, it has 29% for 2015 and 8% for 2016. The group has greater optionality on where to divert capital during weaker price environments, and can reallocate capital from exploration to their highest rate-of-return, risk-adjusted areas. Following multibillion-dollar divestment programs, several have significant cash reserves, which could be used for opportunistic acquisitions. Note: IHS Energy analysis captures derivatives in place for oil, NGLs, and natural gas, predominantly swaps, twoway collars, and three-way collars. For implied weightedaverage prices, the calculations assume a market crude oil price of $50/bbl and a market natural gas price of $3/Mcf. For more information, refer to www.ihs.com/energyhedging US only: 1-844-505-4975 International: +1-303-858-6576 Email: paul.odonnell@ihs.com 8604-0315JK