In the absence of OPEC as a stabilising influence, oil markets have turned increasingly more volatile ... As a best estimate, DBRS anticipates that it will take at least a year before global oil markets rebalance
DBRS foresees no meaningful relief for the oil and gas sector in 2016. Global oil prices and North American natural gas prices have tumbled in recent weeks, reaching lows that have not been seen since the last decade.
Several factors have added more pressure to already weak oil and gas markets, including OPEC’s display of discord at its recent gathering, a continued oversupply of global oil markets, the near-term prospect of additional Iranian oil exports once Western sanctions are lifted, and a mild start to winter in the Northern Hemisphere.
For industry participants, WTI oil priced near USD 35/barrel (bbl), U.S. natural gas at Henry Hub priced below USD 2/million British Thermal Units (mmbtu) and Canadian gas at AECO priced around CAD 2.25/thousand cubic feet (mcf) is causing more stress on balance sheets.
With the considerable level of oversupply in oil markets, DBRS believes there is risk that the price of WTI could breach USD 30/bbl in the short term. However, DBRS does not believe the current price or an even lower price is sustainable for any length of time, although the rebalancing of the market and a material recovery in prices is unlikely to materialise in 2016.
Longer-dated contract prices for both crude oil and natural gas have slid almost in tandem with near-term price contracts. The forward strip contract for WTI oil has dropped to around USD 39/bbl for 2016 and USD 45/bbl for 2017 (as of late December), and the current forward price does not top USD 50/bbl until the latter part of 2018.
However, the picture is somewhat better for natural gas. The strip contract for gas at Henry Hub is around USD 2.20/mmbtu for 2016 and USD 2.70/mmbtu for 2017. The forward price does not reach USD 3/mmbtu until January 2018, and that is for gas delivered during the peak of the seasonal pricing cycle (i.e., the fourth and first quarters).
In the absence of OPEC as a stabilising influence, oil markets have turned increasingly more volatile. The degree of volatility has been amplified as global oil markets and North American natural gas markets remain oversupplied. Continued oversupply will apply additional pressure on pricing until sufficient supply is removed to rebalance the market.
The forward curve points to a period of sub-USD 50/bbl WTI oil through late 2018.
Structurally, the massive development of shale oil in the United States has lowered the global supply cost curve in addition to making OPEC largely irrelevant as a cartel. Nevertheless, the economic returns for developing even the better shale opportunities, as gauged by industry participants, does not justify investing capital at current price levels.
Capex declines and the significant decline in drilling activity in the U.S. shale oil regions, Canada and internationally will inevitably have a meaningful enough impact that supply and demand will balance, supporting a stronger price profile. However, markets will remain volatile, and projecting the timing of a sustainable recovery is difficult given that any near-term price recovery will invite producers to restart marginally economic production.
As a best estimate, DBRS anticipates that it will take at least a year before global oil markets rebalance. To differing degrees, companies have counteracted the pressures on balance sheets with cost-cutting initiatives, capex reductions, improving capital efficiencies and asset sales.
However, DBRS notes that improvements to be realised from future cost-cutting efforts and efficiency gains are unlikely to be nearly as extensive as previously achieved gains. Moreover, the ability for companies to sell assets and employ hedging in a weaker pricing environment is fading. Coupled with diminished access to capital markets, particularly for non-investment-grade credits, the ability for companies to refinance maturing debt and conserve liquidity is becoming increasingly more difficult.
DBRS expects that further capex cuts, even considering additional drilling and capital efficiency gains, will make it even more difficult for companies to offset declines from their base oil and gas reserves and sustain production levels. DBRS anticipates that a mounting number of companies will produce lower volumes in 2016, adding more stress to cash flows and credit metrics.
However, integrated oil companies that have downstream businesses and have benefited from higher margins on the back of falling prices are significantly better positioned to withstand the pressure.
For non-investment-grade issuers, the next round of borrowing base reviews in the new year are likely to result in further impairments to bank facilities, adding to liquidity pressures. Lower prices are liable to have an even greater impact in the coming round, as more reserves (particularly proven undeveloped reserves and proven and undeveloped heavy oil reserves) are at a higher risk of downward revisions and are excluded in the assessment if they fall below the economic threshold needed to be considered proved.
As a result of the change in outlook, DBRS is in the process of undertaking a full review of its oil and gas portfolio. As part of the review, DBRS will extensively stress test the portfolio using a number of oil and gas scenarios, including the current forward oil and gas futures curve as a yardstick. Stress tests will focus on the effect of prices on (1) internally generated cash flow, (2) discretionary versus committed capital expenditures, (3) dividend flexibility, (4) planned asset dispositions, (5) covenant tests, (6) available liquidity, (7) key credit metrics and (8) a recovery rate analysis for high yield credits.
In its review, DBRS intends to underscore the balance sheet strength, size, diversity and cost of a company’s production base, the company’s overall cost structure, quality of assets, integration (i.e., downstream) and liquidity. Just as critical will be assessing management’s willingness to exercise capital discipline in the current environment to maintain balance sheet strength.
DBRS will also consider that it is carrying out its portfolio review at a lower point in the commodity price cycle. As a result of the expected further erosion in oil and gas company fundamentals, DBRS anticipates the possibility of more widespread rating actions with this review.