Implications of the Oil and Gas Debt Crisis
The oil price rally that began in February and peaked in June at over $52 a barrel (WTI) looks to be over, as prices have since plummeted, dipping below $40/barrel as of August 1. Gas prices still look to be rising compared to March lows, yet remaining stubbornly below $3/MMbtu. In other words, price recovery has not been realized.
According to Haynes and Boone, 85 North American oil and gas producers representing over $61 billion in debt have filed for bankruptcy since the beginning of 2015, with 43 producers representing $44 billion in debt filing this year (through June 30, 2016) alone.
The oil and gas debt crisis remains in full swing, with financial agencies continuing to raise alarms and tighten belts.
In July, Moody’s and Fitch rating agencies both warned of increasing high-yield corporate bond default rates in the energy exploration and production (E&P) sector, with Fitch expecting the sector’s skipped payments to total $90 billion by the end of the year.
On July 27, the Federal Deposit Insurance Corporation (FDIC) issued guidance to member banks about the risks of oil and gas lending, and provided recommendations for managing exposure to the oil and gas sector.
The July Shared National Credit (SNC) report – a program implemented by the FDIC, Federal Reserve System, and Office of the Comptroller of the Currency to assess credit risk, trends, and risk management strategies for large (over $20 million), complex loans shared by multiple financial institutions – found the significant decline in oil and gas prices has reduced the capacity of borrowers in the oil and gas sector to repay loans.
But what does this all mean?
There are implications for Wall Street investors, geopolitical consequences, election-year significance, community impacts, concerns about a global financial crisis, and more.
An underreported analysis by Deloitte indicates the oil and gas debt crisis will likely result in underinvestment in the E&P sector, reducing availability of fuel supplies in the future. Deloitte’s theory suggests that low oil and gas prices have resulted in massive (around 50 percent in 2015 and 2016) reductions in capital spending to replace proved reserves. Typically, 80 percent of E&P spending goes towards replacing depleted reserves, which helps firms ensure future product supply availability. This 80 percent number is just to keep production flat to keep pace with demand, and does not account for growth. Capex cuts have forced E&P firms to underinvest in securing replacement reserves, which Deloitte translates into a supply crunch surfacing three to five years from now.
If Deloitte is right, we can expect the supply crunch to translate into higher prices for oil and gas. Assuming there is no significant technology innovation realized to bail out the sector and OPEC passes on a supply injection to reduce prices, the impacts could be difficult.
At home, U.S. motorists are perhaps accustom to oil price volatility, with gasoline price increases being painful but not unprecedented. Sustained high oil prices may make more fuel efficient cars or alternative fuel cars more attractive.
On the other hand, the unknown will be how electricity markets will fare as the U.S. power supply has recently been dominated by natural gas. Short term increases in gas prices will likely result in reduced dispatch of existing gas-fired power plants and greater reliance on coal capacity. There could also be issues related to meeting winter gas demands for both heating and power, exacerbating price increases. Longer term, higher gas prices will likely increase investments in new renewable capacity.
Another unknown will be how U.S. exports of LNG, for which export capacity is currently ramping up, will serve to exacerbate potential price shocks.
While future impacts are unclear, the financial realities of the present low price environment are coming into greater focus.
