lower oil price+=less new drilling
Sharply lower oil prices have two main effects on the planning of new drilling by oil exploration companies:
–the more obvious is that they are only getting about half as much for the oil they are selling today than from output they sold half a year ago. If production is constant, their cash flow has been cut in half
–the second is that projects on the drawing board and highly profitable at $100 a barrel may not be moneymakers at $50.
For both these reasons, less cash flow and fewer winning projects, exploration firms are cutting their capital spending budgets for 2015.
also…
–when prices are rising, oil explorer/developers tend to build up large inventories of supplies for “just in case.” Instead of having, say, a three-month supply of the steel drill pipe that lines the walls of the wells, companies may want six months’ worth. Now that drilling may only be half the level originally anticipated, a wildcatter could be saddled with what is now a year’s worth of pipe, or 4x what he could carry in normal times. And he’s looking to save cash.
One of the company’s first calls is to suppliers. It will want to cancel any outstanding orders–and to see if the supplier will take back some of what the firm already has in inventory.
It’s no surprise, then, that US Steel just announced layoffs at a big steel pipe-making plant.
–In good times, banks are happy to lend. Wildcatters–natural optimists and not very risk averse–are eager to borrow.
I remember talking in early 1982 with the CFO of a mid-sized oil explorer that a short time later went bankrupt. He said that over the preceding few years he routinely went to the local bank for drilling loans, which were always promptly approved. He assumed the bank had done all the analysis needed to determine that the project was sound; the chief loan officer assumed that because the CFO had an MBA he had done the work. In reality, no one had. Whoops.
During the same period, a small Oklahoma bank called Penn Square (located in one tiny office in a strip mall) originated tons of drilling loans, supposedly vetted by expert loan officers and collateralized by oil and gas assets, and sold them on to other Midwestern banks eager to participate in the late-1970s drilling boom. Turns out no screening was done …and documents securing the collateral were never signed.
In today’s world, a lot of drilling finance has come through junk bond issuance rather than bank loans. That may be a plus for the exploration companies, if lenders have done their usual poor job of protecting their own interests through debt covenants.
At any rate, I think the bad debt story for drilling companies has just begun to unfold.
a price turnaround?
At some point–which I don’t think is anywhere close to today–at least a few savvy producers will begin to withhold production from the market. This will come as/when they think oil is too cheap and likely to rebound in price within a relatively short period of time.
We’ve also already seen American car buyers adjust to lower gasoline prices by starting to favor gas guzzling cars and trucks again.
However, like any other commodity, the bottom for oil will come when the cash flow of the highest-cost firms turns negative and they cease production. My not-very-well-informed guess is that this is between $40 and $50 a barrel.