Monday, August 7, 2017

Why is too much debt so dangerous for oil companies?

An oil company is very sensitive to debt because it is a ‘capital intensive’ enterprise.  It spends relative little on wages and equipment but it needs lots of capital to find hydrocarbon reserves and to grow those reserves.  Reserves are strange things. They fluctuate not only because of the technical uncertainties they pose. A change in technology may result in higher recovery factors from a reservoir, say it increases from 6 to 7% that means your recoverable reserves increase by 15%. Say the oil price drops from $70 to $50 and now a reservoir may no longer be economic to be produced and the whole thing gets written off or a significant proportion thereof.  When geologists ‘calculate’ or better estimate the proportion of water in a hydrocarbon reservoir (officially referred to as water saturation (SW) it can easily by out by 10%. Say we calculate an average SW of 60% but then we redo the calculation and find it 'is' 54%, that means the corporate reserves incease by 10%.  
The reserves are a corporation’s assets and if you valued them at $600 million and you lose because of any reason 10% of its value, your assets lost $60 million in value. What if those assets secured the corporate debt; how would a creditor look at that?  That is why often oil and gas companies are sold based on actual production. You may hear that a company sold assets for $40,000 per producing barrel of oil. But the quality of that production (how long and how much is the decline of that production?) is often just as uncertain as reserves numbers and would you value the reserves as zero?  Tell that to oil sands mines; they see you coming.  What about the facilities; pump jacks, gathering systems and pipelines?  Are they 30 years old or only 5 years?  How are they maintained and what are the environmental liabilities? Buying and selling oil or gas assets is a risky game and so is financing them.

Many companies are reporting EBITDA (earnings before interest, taxes, depreciation and amortizations) or operating income. So do oil companies. Have you ever seen the price of Kraft macaroni falling by 50% over a longer period of time, apart from the occasional sale?  Well, oil and gas take prices as set by the market and it is a real circus. If your oil price falls buy 50% during a down turn so does your revenue and your EBITDA may fall by a lot more because your operating costs do not change right away and to a much lesser degree.
Operating income is not net earnings because when you produce oil and gas your reserves deplete and knowing the uncertainties of reserves determination, how much capital do you need to invest to replenish those reserves and how much more do you need to grow the company? Every year, oil and gas companies set their capital budget and you can see how much uncertainty one has to deal with.  Where is the capital coming from?  Out of operating earnings or EBITDA! 

Now EBITDA are not net income! Because, just like real estate, many oil and gas producers use leverage to increase their net income or better their net income per share and their return on equity. Interest and income taxes are paid out EBITDA.  What’s left is used for capital expenditures and dividends and debt repayment.  If oil prices fall, interest payments typically don’t. In fact, the market including lenders may no longer wish to provide financing as reserves that back loans are suddenly worth a lot less and lenders may demand much higher interest rates. If rates increase from 3 to 4%, interest payments increase by 25%.  Lenders may demand repayment of their loans.  With reduced EBITDA how does one pay for the suddenly much higher interest rates, the capital expenditures to replace reserves, and taxes from the good times and debt repayment demands?  Well the first thing that goes are capital spending and dividends. That is the beginning of a downwards spiral. Because if you cut dividends how can you raise new capital through IPOs unless you do it at fire sale prices?  But how can you repay your debt if EBITDA is barely sufficient to pay for the interest?  Raise money by selling oil and gas assets that nobody suddenly wants?

You may now have an idea how dangerous debt is. Typically, an oil and gas company should have not more than 30% of its holders’ equity as debt. But during booms many ambitious managements and greedy demanding investors go for much higher ratios and that spells often the end of a company during the unavoidable downturns. You see, 30% debt/equity may not seem much for say real estate, but how often do you see rents fall by 50% or more?  Well, in oil and gas, that happens every 3 to 8 years and investors as well as poor managers often forget that after ups there are downs.   And it is often the shareholders and employees that pay the price.
Oil and gas companies, as well as many other resource industries are price takers; they often face high price volatility from a manic market . The  only way you make money in oil and gas investments is to buy them when they are in the dog house and sell when everybody loves them. They are under no circumstances buy and hold unless you are the insider and you control the debt.

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