Oil collapse couldn't come at worse time for industry

The US energy industry was licking its wounds when oil recovered to the $60 level in April. Now, with the price of a barrel back in the $40s, the industry mood is dark, with an outlook for lower oil prices well into next year, meaning more shelved projects, deeper cost cuts and tighter-than-expected funding.

Funding is the life blood of U.S. energy supply, as it provides cash flow for an industry that needs to make capital expenditures in order to make money. A cutback in funding could mean less drilling, which is bullish for the price of oil, but negative for companies seeking to generate cash flow.

That makes the price of oil the wild card-and all the more important as fall approaches. October is when bank lenders perform a biannual review of the loans and revolving credit they make available to exploration and production companies, particularly those in the high-yield space. But because of the sharp drop in crude prices and weak outlook, banks are looking more broadly at their exposure across the industry. And for a small universe of the riskiest names, credit lines could be reduced or cutoff.

"We're in a new regulatory world for banks. They have less flexibility to be forgiving, less ability to be flexible, so producers are going to feel the financial pressures. The majors, with their cutbacks in investments, are girding for a period of lower prices, not necessarily in the $40s, but they're preparing for a more bearish outlook for oil," said Daniel Yergin, vice chairman of IHS. "Coming out of the second quarter earnings, the outlook is more bearish at least into 2016."

Daniel Pickering, co-president of Tudor, Pickering, Holt and Co., said he does not expect the indus- try to take a big hit in terms of borrowing ability this October, but the weaker companies could feel the pinch.

"The combination of the low prices and debt, that can be a tsunami. Debt in and of itself is not that big a deal if the price is mediocre. It's a much bigger deal if the price is bad, and a much bigger deal if the price is bad for a long time," he said. "If it goes to $30 and is sitting at $30 in October, that could be very meaningful. Oil at $45 is pretty meaningful. Oil at $60 is not that meaningful."

Pickering said that as far as oil production goes, the funding cut- back this fall should affect only a trickle of U.S. output. The next review, in April, could be much more impactful, experts say.

The drop in oil has slammed companies from Exxon to the smaller names in the high yield space. None have been spared the pain of a sharp reversal in crude, and majors like Royal Dutch Shell (London Stock Exchange: RDSAGB) and Chevron (NYSE: CVX) are putting aside future investment and shaving costs. Chevron has frozen its dividend, and Shell, reporting lower earnings, said last month it was cutting back investment and laying off 6,500 workers.

The oil sector has been punished in the markets, with the biggest names, represented by the S&P energy sector, down almost 30 percent in the past year. According to UBS, the earnings of upstream energy names in the sector were down 74 percent in the second quarter, reflecting the dramatic reduction in energy commodity prices.

But some smaller companies that are heavily dependent on leverage, such as MidStates Petroleum (NYSE: MPO). have seen even more dramatic declines in the market. MidStates' stock fell from the $70s last summer to under $3, and its debt was recently trading at less than 40 cents on the dollar.

The majority of borrowing in the oil patch has been in the corporate debt market. While there are plenty of investment-grade companies, E&P companies comprise about 7 percent of the high-yield debt market. About 41 percent of that is distressed, according to Michael Contopoulos, head of high-yield strategy at Bank of America Merrill Lynch.

If the price of oil remains at current low levels, defaults could go from a current pace of 10 percent in the energy sector to 20 percent, he said.