Photographer: Brittany Sowacke/Bloomberg

Apocalypse Not-Quite-Now for Oil Producers: Liam Denning

If you watch oil markets, you have reason to feel nervous heading into Houston these days. But the most horrific thing about the city turns out to be the traffic on the Sam Houston Parkway. Expecting a scene from “The Walking Dead," you’re greeted instead with cranes over the skyline.

Is this just evidence of pure Texan grit? No. Rather, Houston is poised between the legacy of an earlier boom and the growing impact of a bust. The same can be said for the exploration and production sector that calls it home.

Houston suffers when $50 a barrel suddenly seems like a good price. Those cranes are real enough, but the strain is showing: Private housing starts there fell almost 8 percent in August, year over year -- nothing like the double-digit slump seen in the financial crisis, but still heading the wrong way.

The oil and gas industry, in parallel, is facing apocalypse deferred rather than now. This month, many E&P firms will find out how much their banks are willing to lend against the value of their reserves. These assessments usually happen in the spring and fall.

Oil futures have moved lower all along the forward curve relative to a year ago and last spring.

It’s unlikely anyone was looking forward to these talks. Indeed, releasing a survey of lenders and borrowers last month, law firm Haynes and Boone said the attitude of “wait and see” that held in the spring had given way to a recognition that action was needed in terms of raising money, restructuring or even declaring bankruptcy.

Yet while banks will almost certainly give a sharp tug, there are reasons to think they won’t pull the rug from under the E&P sector completely.

A few companies have announced the results of talks already, such as Oasis Petroleum. Its ratio of net debt to trailing Ebitda hit 2.91 times at the end of June, up from 2.05 times a year before. Estimates compiled by Bloomberg point to it burning more cash this year and next. Yet its overall borrowing base was only trimmed from $1.7 billion to $1.525 billion. And that latter number equates to the level of committed credit Oasis had in the spring, so the immediate impact on liquidity looks even less significant.

Meanwhile, analysts at consultancy Wood Mackenzie estimate that at least two thirds of oil and gas production in the lower 48 states comes from companies that either don’t use reserves-based lending or aren’t scheduled for reassessments before next year. For those that do face reviews, most would need to see their lines cut by more than half to be in imminent trouble.

While banks are under more pressure from regulators to tighten lending standards, they also don’t want to push clients into bankruptcy and potentially end up owning acreage in Texas or elsewhere.

That, along with the recent rally in oil prices, may keep the emphasis on E&P companies pulling more levers rather than banks pulling the plug altogether. Witness how Chesapeake Energy, which has seen its stock cut in half this year, recently struck a deal to shift an existing $4 billion unsecured line of credit to a secured one. Tighter lending? Yes, but Chesapeake gained a little breathing room nonetheless.

And yet, there’s no escaping that this industry is now roughly a year into a crash. Overall, it will likely exit October with less liquidity.

And by the time E&P firms sit down next spring, they will need to have seen a recovery in oil prices -- not least because they have hedged much less of next year’s production than this year’s, meaning less certainty on cash flow. Wood Mackenzie estimates hedging benefits will be cut by around $7 billion next year for its sample of larger companies.

It is the minnows that are really in the crosshairs, though. In a report published Monday, Raymond James estimated that 27 small and mid-cap E&P companies could see their borrowing bases cut by between 20 and 25 percent on average compared to where they stood in the spring. 

While oil prices haven’t moved much since then -- three-year average forward prices are down 9 percent since April 1 -- lenders will be mindful that equity and high-yield markets have largely closed to new E&P issuance in the meantime and hedges are rolling off or close to doing so. And come next spring, the slowdown in drilling now will show up in minimal reserves growth, further constraining borrowing capacity.

Barring a sustained recovery in oil prices, therefore, it may be that Houston’s big industry is simply entering the third phase of this bust. The first saw E&P firms scrambling to sell shares and bonds in a public market where optimism hadn’t yet faded. That largely ended by the summer. The second, perhaps ending with these latest talks with lenders, involves putting off doomsday by renegotiating borrowing in a way that still leaves the window open for an oil-price recovery.

The third, which we could see play out in the first half of 2016 as lenders tighten even further, would involve capitulation.

It is notable that merger activity has been relatively subdued in the oil patch. In the first three quarters of 2015, 183 deals worth $37 billion were announced in the U.S. E&P sector, versus 269 worth more than $100 billion in the same period last year, data compiled by Bloomberg show. Moreover, asset deals, rather than corporate takeovers, continue to dominate, accounting for 60.4 percent of total M&A volume in the four quarters through September. And there hasn’t been a marked uptick in private equity buyouts in the sector, either.

It may well be that potential sellers are suffering, but not suffering enough yet to sell out or cede control. That makes sense: What oil baron likes to spend years building a shale empire only to sell out at the bottom of the market?

The signs suggest that they can continue to hold out a little longer. Yet this resistance to consolidation perpetuates the root cause of the problem: low oil prices. The smaller companies in Raymond James’ analysis account for less than 10 percent and less than 5 percent of anticipated U.S. crude oil and natural gas output, respectively, this year. So while at the very least they will shrink production, it likely wouldn’t move the needle much. Without that, oil prices will take time to recover -- and a reshuffling of the sector’s assets looks set to get underway come the new year.

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