A vicious bear market has taken hold of world energy markets. Following the oil shock of 2014, the price of oil has halved again during the past year.
As revenues disappear for global oil and gas companies, so have their opportunities to finance any growth. Most exploration and production (E&P) companies invest beyond their cash inflows, counting on equity and debt investors to fill in any gaps.
These E&Ps have had to slash their spending to save money, not just in shale oil regions, such as North Dakota’s Bakken, but worldwide.
Capital spending for US oil and gas explorers fell about 40 per cent last year, according to Credit Suisse. A drop of a third is forecast for 2016 and, as a result, equity and debt issuance declined 35 per cent in 2015, says data provider Dealogic — the largest drop since 2000.
Those numbers tell only part of the story. US equity financing actually held up well — roughly flat on 2014 — owing to a strong first half.
Helped by a brief rebound in oil prices last spring, investors seemed prepared to offer capital believing that energy prices could rebound.
Outside of North America, E&Ps have struggled, raising only about half of the debt and equity that they raised in the previous year, according to Dealogic. In Europe, companies have had to rely mostly upon refinancing via bank credit facilities.
Last summer was a busy one for some European bankers. Exploration companies borrowed or refinanced, sometimes using their oil reserves as collateral. Some, such as EnQuest and Premier Oil, used the opportunity to renegotiate terms with their lenders.
Christophe Roux, head of reserve based finance in Europe, the Middle East and Africa for Société Générale notes “the oil finance market was very liquid”, in other words active, during the summer. Relying on debt, rather than equity, also forced some E&Ps, such as EnQuest, to employ more hedging to protect their ability to repay these loans and credit lines.
Yet, any optimism in a recovery for oil prices back in the summer has vanished. Oil executives have resigned themselves to energy prices that will be lower for longer.
Of the smallest explorers, those listed on the UK’s AIM, almost all were making pre-tax losses in their most recent accounts, says research firm Company Watch. Last month, AIM-listed Iona Energy called in the administrators.
“You don’t hear the level of conviction [from other oil executives] you heard in March-April,” says a former chief financial officer at a UK-listed E&P. “Hope has sort of dissipated.”
European oil companies have already increased the focus on their banking relationships, but US E&Ps will also need to hug their banks more than ever in the coming months.
For one thing, the US equity market has little appetite for the energy sector as it becomes less relevant to portfolio managers chasing key index benchmarks. Energy as a proportion of the S&P 500 index has halved since 2011 to 6 per cent, according to S&P Dow Jones Indices.
Meanwhile, the threat of further increases in US interest rates, following the Federal Reserve’s decision in December to raise rates for the first time in nearly a decade means the high-yield bond market — formerly a popular option for US energy companies — is also effectively closed.
High yield spreads relative to US Treasury bonds have moved to their widest since 2011, indicating that the prices of those bonds are falling (or their yields are rising) faster than US Treasuries. Bonds in the high-yield energy sector have twice the spread of all the non-energy sectors.
The disappearance of alternative sources of finance means that the banks’ valuation of each company’s hydrocarbon reserves, used as collateral against bank loans, will be vital.
In the US, these discussions between lenders and their clients over the value of their reserves will probably go less well than last year.
“If oil prices are in the mid-30s, banks are finally going to drop the hammer a bit more than they have in the past,” thinks Paul Grigel, E&P analyst at Macquarie.
Apart from a major recovery in energy prices, one factor that could drive increased activity in oil and gas equity and debt issuance is a forecast rise in merger and acquisition activity. “Should the current pricing gloom persist, we expect that deal flow will increase in 2016,” note energy consultants Wood Mackenzie.
“The drivers behind deals, and the types of deals we see, will differ this year as potential sellers come under increasing financial pressure,” they add. Similar sentiments were expressed following the announcement of Shell’s $82bn acquisition of BG Group last April. Yet that takeover did not spark more activity. Remove that deal and energy M&A worldwide fell by two-thirds in 2015.
Another group to watch will be the oil-producing countries themselves. Saudi Arabia surprised the market last month when the government said it would consider listing part of its state oil company, Saudi Aramco. Nigeria has announced similar aims. Both Brazil’s Petrobras and Rosneft of Russia will also need to consider alternative ways of financing to meet investment plans.
Whatever happens to energy prices, pressure on balance sheets will continue. While the likes of Exxon and Shell worry simply about meeting the dividend demands of shareholders, a larger drama will play out among the smaller oil and gas producers fighting for survival.