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

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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