Financial hurricane in the global oil and gas industry
- Written by Laurentiu Rosoiu
By retesting the lows recorded right after the financial crisis, the fall in oil prices pushes a number of increasingly large companies in the oil and gas industry off the market; over indebted, with ratings or rating outlooks revised downward for more and more players in the field, with massive decline of stock prices and with significant increases in the risk and yields of bonds issued... the global industry of oil and gas is thus caught in a real financial hurricane, with its epicentre in the United States, but with reverberations in Central and Eastern Europe. As analysts’ outlooks show that prices will continue to evolve unfavourable for the industry over the next two years, while 2016 and 2017 are also years with peak loads of debt repayment, we expect a period in which bankruptcies, sales, mergers and acquisitions will take place, most likely, more often and with ever increased speed.
Being hit directly by the collapse in oil prices since mid-2014, which heavily affected the financial results and led to a massive quotations drop of the companies listed on stock markets, the world industry of oil and gas faces a new round of problems, i.e. the high degree of indebtedness and a more difficult access to capital point to more and more fresh victims among the companies.
By the end of October, when oil was about to test again the threshold of USD 40 per barrel (see the chart ‘Oil is retesting the USD 40 per barrel threshold’), Moody’s gave the industry a new negative impetus by announcing that the number of entities with bad ratings in the oil and gas industry is growing. Specifically, according to the release sent on October 23, out of the 223 companies that were on the Moody’s list of companies with ratings below B3 negative, at the end of October 2015, the units in the oil and gas field held a share 23.8%.
The figure is important not only because nearly a quarter of the companies on the list were from that field, but especially from the dynamics point of view: more exactly, by the end of October 2015, the share of companies in the oil and gas field on the list was significantly higher than the one recorded by the end of the previous quarter of only 19.3%; altogether, the share is much higher than a year ago, when this industry had a share of only 8.5% of all companies on the list. Moreover, even the Moody’s analysts emphasized in the release that the overall negative trend (given that the number of companies with poor ratings on the list was by 8% higher than at the end of the previous quarter and by 27% higher against last year) was caused particularly by the negative development registered by companies in the oil and gas industry. “Many of the companies in the oil and gas field, particularly those operating in exploration and production, are being hit by the great pressure on liquidity and this has led to lower ratings,” Moody’s analyst Julia Chursin said in that statement, which she warns that “by maintaining this pressure, we expect a growth in number of companies in the energy sector that will enter the list.” This will take place in the context in which many companies are already out of that list through bankruptcy during the last three consecutive quarters, as specified in the release, many more than those which have managed to go up through the revisions of ratings. The highest number of bankruptcies occurred, as stated in the release, among the independent companies in the exploration and production field and in the auxiliary services, the fields that felt the strongest pressures posed by reduced access to liquidities and by the earnings collapse.
The industry’s majors are not doing better. A lot of the large companies have seen lately consecutive ratings cuts or at least a worsening in prospects. E.g., in July this year, S&P had announced the downgrading of Royal Dutch Shell from AA to AA-, the subsequent decision to the one by the end of last year, when the S&P analysts had cut the rating outlook for Royal Dutch Shell to negative; on the same occasion, at the end of 2014, the S&P analysts announced the reducing of the rating outlook for several other European giants from ‘Stable’ to ‘Negative’: BP, Total, ENI, Repsol and Statoil were among them. In July 2015 the list of major European companies with lower rating outlook (to the negative) also included the Hungarian company MOL. The list could go on with other companies and with similar decisions issued by other rating agencies. In contrast, by way of example, in late August 2015, S&P confirmed the rating and the positive outlook for Austria’s OMV.
INDEBTED AND HAZARDOUS MARKETS
The avalanche of rating outlooks cuts, both for the large and for the small players in the field, is the latest and one of the strongest blows for the industry, as a whole; having declining ratings (or having the outlook turned to negative) the investors’ willingness to place their capital in these companies is strongly inhibited, leading to o limited access to financing for the companies in the oil and gas field.
The falling ratings, meaning reduced access to capital, are therefore a real problem for an over-indebted industry which has to cope with a debt repayment peak during the next two years. At the end of 2014, according to a report issued by BIS (Bank for International Settlements - institution based in Basel, Switzerland, which acts as central bank for national central banks), the companies in the oil and gas field had overall liabilities (in the form of bank loans, bonds, etc.) amounting to USD 2,500 billion. Of this amount, according to a study published by BMI Research in early August 2015, no less than USD 550 billion are loans and bonds due in the next five years, of which USD 300 billion are due by the end of 2017 (i.e. about USD 72 billion due in 2015, USD 85 billion due in 2016 and USD 129 billion are due in 2017) (see the chart ‘Loans and bonds of the global oil and gas industry’).
The same BMI Research survey shows that the players in the exploration and production field (the most affected market share so far by the fall in oil prices!) by mid-2015 amounted global loans and bonds worth USD 639 billion due in the next ten years; about USD 115 billion of this amount (18%) is due in the second half of 2017 (see the chart ‘Loans and bonds worldwide in the E&P segment’).
By country of origin, the US companies are by far the most indebted, and the top five most indebted markets (US, Canada, Mexico, Kazakhstan and Australia) sum up debts of USD 417 billion (65%) of the global debt registered by companies in the exploration and production field (E&P) (see the chart ‘Most indebted E&P markets’).
By comparison, the integrated companies (operating in all the market fields, known as IOC – Integrated Oil Companies) get an even more tough effect of debts. By mid-2015 they recorded debts due in 2017 of approx. USD 159 billion (or some 29% of the total debts of the integrated oil and gas companies, due in 2025, of USD 584 billion) (see the chart ‘Debts of integrated oil and gas companies (IOC) due in 2025’). Meanwhile, following the distribution of IOC debts by country of origin, Russia (approx. USD 60 billion) and China (approx. USD 40 billion) join the US (approx. USD 50 billion) in dominating the most indebted markets (see the chart ‘Most indebted markets according to IOC indebtedness’). The figures in the BMI Research survey show quite clearly that the United States can be called, without much doubt, the epicentre of the financial hurricane that destabilize the global oil and gas industry; Russia and China closely follow the US.
It is to be noted that, when comparing the size of the local market to the outstanding debt, the BMI Research experts believe that the market in Central and Eastern Europe (CEE) faces a quite delicate situation. “Given the size of the local market, the debt burden of the companies in the region is disproportionate,” the BMI analysts say in the same report “Rising Debt: Emergent Risk to Oil & Gas Sector”, supported by figures. According to them, the Hungarian oil and gas industry alone totalled about USD 2 billion in debts due in 2017, while Poland, Austria and Romania also had some USD 2 billion in debts with the same maturity (see the chart ‘Central and Eastern Europe (ECE), among hazardous markets’).
THE WAY HITHERTO
The financial hurricane’s harshness for the global oil and gas industry is not complete, however, without the dynamic image during the last decade. A period in which the aggregate value of the industry’s debt has grown from USD 1,000 to USD 2,500 billion! BIS detailed figures show that the value of debts contracted by the oil and gas companies through bond issues has grown at a rate of 15% per year, from USD 455 billion in 2006 to USD 1,400 billion in 2014; concomitantly, the value of bank loans contracted at industry level grew at a rate of 13%, from USD 600 billion to approx. USD 1,600 billion.
The BIS survey ‘Oil and Debt’ conducted in early 2015 shows that after 2008-2009, a major inflection has taken place worldwide, as the amount of debt contracted through bonds issuing by the oil and gas companies exceeded those contracted through bonds by companies in other sectors; the trend has been maintained so far, so that by mid-2015 the difference between the two values was of more than USD 2,000 billion (see the chart ‘Credit bubble in the oil and gas sector’). It should be noted that, much of this increase is coming entirely from public integrated companies held by the governments of emerging countries. Thus, from 2006 to 2014 the stock of debt (bank loans and bonds) held by Russian companies have increased by an annual rate of 13%; the growth rate of Brazilian debt stock was 25%, and of Chinese companies 31%; the annual growth rate of the debt stock of companies in other emerging economies was 17%.
For most of them, however - which had already increased production capacities and thus increased prospects for producing revenue - the indebtedness growth coincided with a period in which they made massive payments of dividends to their shareholders (national governments are usually the majority shareholders). Therefore, the oil and gas companies from emerging economies have used the pattern of other large companies holding liquidity, of very low interest rates for the return of capital to shareholders.
Although in terms of dynamics the companies from emerging economies have easily been ahead, the US companies are by far the leaders in terms of weight, holding by mid-2015 approx. 40% of the worldwide total contracted bank loans and/or through bonds. Most of these debts were contracted by small companies, especially those engaged in the exploration and exploitation of alternative deposits. These are companies that have borrowed heavily to finance the increase of production capacity, often on the background and/or despite the decline in revenues; players in the exploration of alternative deposits hold thus a large share of the total investments made in oil and gas industry - where, during 2000-2013 the annual amount of expenditures/capital investments doubled, reaching USD 900 billion (according to the IEA 2014 report).
The combination of falling prices and higher loans generated a series of major pressures on the companies’ finances. Firstly because the fall in oil prices leads to lower value of the assets on which the companies have guaranteed the borrowings; so that on each review of the deposited collaterals, their value has decreased, significantly reducing the amount of financial support lines. Secondly, the decline in oil prices has reduced the revenues and the profitability profile, putting them in a position to be unable to pay their debts, thereby facing increasing risk of bankruptcy and increased financing costs. And this is clearly seen on the bond markets, where the yields of the bonds issued by the oil and gas companies have spectacularly increased due to lower prices - which mainly reveal the hazard increase associated with this industry.
According to the same BIS report, the spread between yield of bonds issued by companies in the energy sector and the yield of US’s ‘Treasury notes’ (bonds due in up to 10 years issued by the US Treasury) has increased from 300 basis points in June 2014 to about 800 basis points in early 2015; this is the indicator comprising only bonds below the recommended level for investment ratings. For comparison, the difference between the yield of the same type of bonds, non-investment, degrees issued by companies in other fields (red line) and the ‘Treasury Notes’ is just a little bit over the 400 basis points, which indicates that the risk and cost of financing in other fields is about half of that associated with bonds of companies in the energy sector (see the chart ‘Bond yields, at maximum after the financial crisis’).
And this phenomenon is not only valid for bonds with poor ratings! The same trend (of growing spreads and/or yields) is visible also for the ‘investment grade’ bonds – i.e. those having a rating which recommends them as good investment; Thus, the spread between the yield of bonds issued by companies in the oil and gas industry rated ‘investment grade’ and the yield of US’s ‘Treasury Notes’ is also rapidly growing since mid last year. This difference increased from 120 to 240 basis points in early 2015. Thus, the level of yields, and hence the cost of funding, is almost double for oil and gas industry against the bonds issued by companies in other sectors (see the chart ‘Bond yields, at maximum after the financial crisis’).
Increasing differences between the yields of bonds issued by companies of oil and gas (and the ones by companies from other sectors) and the yields of ‘Treasury Notes’ issued by the US Treasury is a result of the growing yield of corporate bonds (issued by companies, either by the ones operating in oil and gas, or in other fields); their yields evolving in the opposite direction against prices, due to lower prices due to massive bond sales. Moreover, by mid-2015, the number of companies with yields of over 10% (which is an indication of the company’s level of risk and that the company is facing problems in financial terms) almost tripled over of previous 12 months, up to 168 entities (on all continents!); the ratio of net debts and the revenue levels is also at the highest level in the last two decades.
DOWNFALLS ON THE STOCK EXCHANGE MARKETS
If in the first instance, late last year and early this year, the need for capital could be at least partly covered by the sale/issuance of new shares (in return for which the companies have received capital from investors), the developments on the stock exchanges in the last 12 months of the companies in the oil and gas industry show that this form of financing is almost impossible now! This is because, in the last year, the oil and gas industry has had the worst stock market development - which, obviously, chases away potential investors. According to data provided by Stoxx Ltd. (one of the most important creators and providers of financial indices globally), the Stoxx Global 3000 Oil & Gas index recorded at the end of October a loss of 11.5% during the last 12 months and a minus of 4.7% against the end of 2014.
The Stoxx Global 3000 Oil & Gas index is tracking the overall evolution of the oil and gas companies included in the most important 3,000 companies worldwide operating in all areas of activity (i.e. a total of 167 oil & gas companies, including Romanian company OMV Petrom). This index describes the worst development of all nine relevant sector indices calculated by Stoxx Ltd (see the chart ‘Negative trend on the stock markets’). By comparison, at the other end, the Stoxx 3000 Consumer Services index recorded, during the same intervals, increases of 28.8% and 13.7% respectively, while Stoxx 3000 Consumer Goods index was registering yields of 23.8% and 13.3 % respectively.
CHALLENGES, RESPONSES AND PROSPECTS
These cumulated problems can be approached by the companies facing the decrease in oil prices in two ways. The first form of response is to continue adjusting the investment programs, the expenditures and production. As a great part of investments is financed on credit, tighter financing conditions will deepen the reduction of capital expenditures, the highly indebted companies being forced to sell assets, including rights/licenses for exploration/exploitation or manufacturing facilities and/or equipment. At the same time they will have to maintain or even increase the level of production, even if the price will continue to drop, in order to maintain the revenues at a level enabling them to obtain the necessary liquidity to honour debts and to maintain access to financing on an increasingly restrictive market.
The second form of response that the industry has in hand is that of ‘hedging’ against future volatility in the price - by selling production in advance. Heavily indebted manufacturers will thus be faced with the option to enter more aggressively on the markets for derivatives, by selling ‘futures’ contracts or by buying options in an attempt to protect sales prices if the price continues to drop. Paradoxically, this pressure on the market quotations of oil derivatives financials will be transmitted on prices on the spot market, amplifying the negative trend.
Both forms of response thus lead to pressure on oil prices! Even if divergent, they will not compensate, but rather will accentuate the volatile market climate, with all the risks and adjacent problems. Thus, on the one hand, reducing investment will put upward pressure on prices - the logic being that this phenomenon will lead to lower production. On the other hand, if current constraints on access to capital will maintain a high level of production, pressure will mount for sales in advance (on the markets for derivatives and/or contractual agreements between parties!) - which will amplify the downward trend of oil price dynamics. In such a scenario, the probability for the industry to enter a new cycle of ‘deleveraging’ is likely - withdrawal from the market through debt relief, through investment and new assets sales.
Unfortunately, the outlook does not look at all optimistic. At least if we consider the oil price projections made by the Moody’s and/or S&P analysts. Thus, by mid-October 2015 Moody’s Investors Service reduced estimates regarding oil price, saying it will increase in 2016 and 2017 at a significantly lower rate than previously expected: the Moody’s analysts reduced the price estimate for 2016 from USD 57 to USD 53 per barrel for Brent oil and from USD 52 to USD 48 per barrel for WTI oil. “We believe that oil prices will remain low for a long period of time and the level of reserves and overproduction will lead to a much lower pace of price increases,” said Steve Wood, Managing Director of Corporate Finance within Moody’s on the publication of the report “Continued Oversupply Compounds Weakening Demand”. “Although the level of production should decrease due to lower capital expenditures, the increase of exports from Iran will lead to further pressure for a downward trend in prices in 2016,” he added.
Moody’s estimates actually complement the negative outlook of S&P analysts, which at the end of September 2015 also announced a downward revision of oil prices estimates for 2016 and 2017. The estimate of the average price for 2016 was reduced to USD 55 per barrel for Brent oil and to USD 50 per barrel for WTI oil; the average price estimate for 2017 was reduced to USD 65 per barrel for Brent oil and to USD 60 per barrel for WTI. As the average oil price estimated by the S&P analysts for 2018 is to be declining (from USD 70 per barrel for Brent and USD 65 per barrel for WTI), amid a peak debt settlement at industry level, it is clear for the players in the field that at least the next two years will be extremely difficult.