Sunday, September 24, 2017

Oil and Gas in debt. Let's try again.


A while ago, I tried to explain why debt and falling oil prices can be so catastrophic. There are a lot of moving parts and there is a lot of technical and economic uncertainty in evaluating the oil and gas reserves that secure the debt. So, below I have created a ‘make-believe’ scenario to better explain (I hope).
Somebody is typically willing to lend you money if you have enough income to pay the interest on your loan and pay back the loan overtime without starving your family. Your house is the security for the loan; that is to say that if you can’t repay the loan, you can sell your house and use the proceeds for repaying the loan.  So if you lose your job and your salary then the bank is likely to tell you that you no longer have the income to repay the loan and thus, you better sell your home or any other assets and repay your debts right away. Now, if you lose your job during a real estate crash then the value of your house may be less than that what you owe and now you are basically bankrupt.

Well, with oil companies, matters are not that different. Your net operating income (NOI) is for interest and principal repayment. Your oil and gas reserves are the security for your debt.  When you get $100 per barrel oil and your operating costs are $40 per oil then you’re making $60 NOI from which you pay the interest on your loans. But… you also must replace the oil reserves that you produced (depleted). So now you have to buy additional mineral rights to own the oil reserves below and you need money to drill a new well and put in place the production facilities to produce that oil and transport it to the consumer.  That money also comes out of your net operating income and is are often referred to as finding and development (F&D) costs.

What remains of the $60 net operating profits after you pay to replenish your depleted oil reserves is your ‘net income’. Although your operating income is $60 per barrel, it may cost you easily another $28 per barrel to find new oil. So your ‘free cash flow ‘ is $32.00 that that may be used for other acquisitions or for paying dividends and so on.  But first you also have to pay corporate income taxes. This is assuming that royalties were included in your operating profits of $60.

As you may have noticed, oil prices are not exactly stable and what would happen to your operating profit if the price dropped from $100 per barrel to $70?  Yes your operating profit falls from $60 to $30 or by 50%. Oops, you still must replace your depleted reserves at a cost of $28 per barrel, eh… so you have only $2 per barrel left in net income and after taxes the money available for paying dividends is virtually zilch!  Be thankful you did not have any debt and interest that needs to be paid!

What?  You took on debt after all?  The stock market demanded that you kept on increasing production and so to pay for all that extra drilling you took out a loan.  With $100-dollar oil what is an extra $10 interest per barrel?  But… every other oil company did the same… how else to keep up with the stock market demands?

Oops, with oil prices at $70, we still have to pay that $10 interest. So now we have a cash deficit; ok we pay it out of the funds for capital program that should have been used to replenish our reserves.  Also, we had to keep up dividend payments and so we borrowed money to get past this short term drop in oil prices. But prices stayed lower longer. Who could have known????  Now we have to cut dividends and nobody wants to invest in us anymore. Our stock is down by 40%.  Well, since we have no money to drill, why keep drilling staff? Layoff the geologists and engineers. Get rid of the drilling rigs. Cut costs!!! Cut costs!!   But now production starts to decline and we can’t pay for waterfloods that are no longer making money. Production falls even more. Now we don’t just make less money on each produced barrel but the number of barrels produced is falling too!  After all, a decline rate of 25% means that our production drops each year by 25% if we don’t drill!   Do you know what the decline is of a low permeable Horizontal Well with multistage fracking?   A lot more!

The banks tell us that we should sell some of our oil and gas reserves to pay back the loans they secured. Eh… oops. You know those reserves that we could produce at a profit at $100 per barrel? Now we’re losing money on them at $60. And the reserves we are no longer worth anything. But the banks want their money back. NOW!  So, what are they worth now, our reserves?   Well we laid off the geologists and engineers. Nobody really knows. We don’t even know how to recomplete or repair wells because the technical expertise was laid off. Let’s temporarily hire some cheaper geologists. Oops they don’t know our properties; besides the old guys made estimates of reservoir thickness and potential amounts of recoverable oil reserves that the new guys no longer agree with. It is easy to be out 10 to 20% in the reserve numbers just on technical grounds and we have to reduce those reserves because many are no longer economic to be produced at $60 dollar per barrel.

So, major reserves write down and our assets (reserves) are no longer worth what we owe. Well, we have to declare bankruptcy! If we had been more conservative regarding our debt or if we had no debt at all, we could have waited until oil and gas recovered but now…  The only thing we can do is sell assets that nobody wants and even banks have to be happy getting 10 cents repaid of each dollar owed.
Ten months later, oil prices are back up but our company is gone!. Our shareholders lost all their equity. Good news though, someone is buying oil and gas assets dirt cheap!  Now that are smart guys. Just pray they can keep production growing. Because that is what we shareholders want: more production!

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