By Michael McDonald, an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. Originally published at OilPrice
A central tenet in the thesis by analysts about the oil markets rebalancing has been that as prices declined, oil companies would be forced into bankruptcy. That in turn would lead to declining production, and eventually a rebalancing of supply and demand in the market, followed by higher prices. That process is already taking longer than many expected, and it looks like more time is needed. That additional time to balance the market is being driven by an unexpected factor; bankrupt oil companies are still pumping.
As oil prices have declined, the number of bankruptcies and distressed oil majors has quickly risen into the dozens. In fact, a recent Reuters analysis suggests little effect on production from when companies enter bankruptcy. Reuters cited Magnum Hunter as a primary example of this reality.
While Magnum Hunter filed for bankruptcy in December 2014, the firm has scrambled even in Chapter 11 to keep its oil flowing, resulting in O&G production rising by roughly one-third between mid-2014 and late 2015. The firm has used the protection bankruptcy courts to help stave off creditors while keeping the pumps flowing full tilt. Nearly all of Magnum Hunter’s 3000 wells are still producing crude, and that makes sense for several reasons.
First, daily costs for operating wells remain well below current spot prices. While drilling new wells is not economical, it is perfectly logical to keep exploiting existing wells. Fracked wells usually start to see a significant decline in production after about two years of operations. So eventually Magnum Hunter and other companies will see their production fall, but two years can be a very long time to pump.
Second, creditors want to extract maximum value from the company and the best way to do that in the current environment is to keep the oil flowing. Bid-ask spreads on oil assets for sale are simply too wide for most companies to be interested in selling assets while in Chapter 11. Instead, creditors maximize the present value of their assets by continuing to pump oil. This oil can either be stored leading to a large risk free profit, or it can be sold on the spot market. Either way, Magnum Hunter and other bankrupt producers are acting in the best interests of their creditors by continuing to pump. Unfortunately, those actions are not in the best interests of the broader industry or energy sector stock investors.
Third, management at bankrupt producers also have little reason to do anything other than keep the crude flowing. In the current energy market, getting a job is very difficult, especially for top managers coming from a bankrupt producer. As a result, managers rationally want to make sure they stay useful in Chapter 11 and that means trying to convince creditors to keep the company operating rather than converting to a Chapter 7 liquidation. Not all O&G firms should be kept operating – some firms are better off being liquidated – but creditors often lack the necessary industry expertise to be able to distinguish between firms that have a future after emerging from Chapter 11, and those that don’t and are better off in a Chapter 7 sale. And again, management has very little incentive to put themselves out of a job by recommending Chapter 7.
On the whole then, while the oil markets are slowly making progress in rebalancing, the process is slower than most investors would like. Bankruptcy alone cannot rebalance the oil markets. Instead, natural well depletion and a lack of new investment are the driving forces that are reducing production over time. Those forces will continue in the future, but for now investors will just have to be patient and not get ahead of themselves.
26 comments
Comments are closed.
For sunk investments (literally) in producing wells , it’s the least expensive option.
Operators owe money. The only way they have to raise money for payments is to sell oil.
When oil is cheap, they have to sell more oil.
Seems pretty simple. What else are they going to do?
Crazy thing is that it may well only be in resource extraction that such an approach would work. This because once the well have been drilled, there is minimal expenses related to continued extraction.
Given this, the recent rise in prices seems quite bizarre – the Forbes article linked in NC two days ago indicates that it may be driven entirely by the futures market, and is not a reflection of a rebalancing of the market.
A key point about fracked tight oil wells is that they don’t just start to deplete after 2 years in a gradual manner – production falls off very rapidly (unlike conventional wells which generally wind down very slowly over many years). This could lead to quite a sudden drop in production, maybe by the end of this year. This could simultaneously lead to a rise in prices (good news for the industry), but a disaster for the investors in tight oil as they suddenly find they have no oil flow at just the point when things are looking up for them.
The creditors’ bonus/commission driven, often non-shareholding CEOs and loan officers also have every reason to postpone posting the final reckoning of chapter 7 on their books, particularly when the CEO and loan officers vastly, perhaps criminally, inflated the value of the assets so that they could maximize their own bonuses. After all it’s just the shareholders (ie: the 99%’s retirement funds) that are going to be screwed even worse when it festers more before it blows up.
Even those CEO’s who receive bonuses as shares or options hope to sell off stocks (and options) which have time restrictions on them have lifted have every reason to hold off the bad news as long as possible, For both groups this is true even to the extend of offering bridging loans (which yet again offer more bonus/commission opportunities).
This is pretty much the biggest issue with the state owned banks in China as well, Actually it’s worse because there is zero reliable independent assessment of assets in China, and because giving a proper evaluation of their worth would destroy the asset base of local governments, plenty of political as well as life & death reasons to allow the situation to fester while preparing for an early exit from the industry. This is why real estate values in any large city that is acceptable for Chinese immigration is booming.
In Oklahoma the state PAYS money losing producers to keep pumping while they starve the schools.
I really have no understanding of this statement! The state of Oklahoma is paid 7% of the gross revenue on every barrel or MCF prodcued in the state? In fact the state has learned to live beyond its means so when prices drop it ends up in a major budget deficit. That production tax pays for many of the teachers in Oklahoma.
A little more on the state of Oklahoma production tax:
In the early 1980s, this was the state’s largest revenue producer. After falling in the mid-1980s and 1990s, the gross production tax rebounded in the 2000s to again be an important tax source. It raised $1.2 billion in 2008 and accounted for one-tenth of state and local tax revenue. Higher prices contributed to a dramatic 39 percent revenue increase in 2006. Revenue grew more slowly from 2006 to 2008. Oklahoma falls behind only Alaska and Texas in revenue from severance taxes, according to the U.S. Census Bureau.
In the liquidation of an exploration company the assets are sold to another oil and gas company and the wells are kept producing. New technology also exists to go into old horizontally drilled wells and rework them bringing production up above the original porduction. In fact some of the service companies are offering this service and will take payment as part of the production, Whoever, owns these assets either banks or oil and gas companies they will continue to invest in these wells (workover is fairly inexpensive) until the last economic drop is produced from them.
Another short coming is the lack of gathering systems in some of the new production areas. Recently performing work for an enterprise building out a gathering system I counted 1,200 wells which were shut in and waiting for the gathering system to be constructed.
Also, while performing work on some Gulf of Mexico producers, I saw that production will continue to increase until at least the end of 2017. Once again there there has been significant work performed putting gathering platforms in place so that production can be shipped to land. The platform I was looking at just went on line late last year and $500 million of additional investment was being performed on this platform to produce from another area. These wells are big producers and have long life spans.
None of this addresses that Iran is back selling into the world market and action is being taken to bring Libya back on line.
IIRC, I’ve read horizontal wells can exhibit a regeneration behavior after being left dormant, so is it reasonable to expect a residual value after the are abandoned after the production inflection point down to exhaustion?
Horizontal drilling is not a new technology nor is fracking, The new technology is the ability to produce from multiple zones at once. Accordingly, you might have one zone play out you can produce from others. Even later you can implement secondary and tertiary methods to produce. For instance they have been using a massive water flooding operation on the OKC field that is close to a 100 years old. It is the disposal of waste water from this water flooding and not fracking that probably caused the earthquakes in Oklahoma.
I was told about 3 years ago that 90% of the original reserves are still in the ground in Oklahoma. The reason that they can not be produced is the cohesiveness at the molecular level but they are working on ways to decrease that cohesiveness. Is that just talk who knows.
Horizontal drilling is not a new technology nor is fracking, The new technology is the ability to produce from multiple zones at once. Accordingly, you might have one zone play out you can produce from others. Even later you can implement secondary and tertiary methods to produce.
Yes that… I seem to recall that played out horizontal wells have been revisited and hydrocarbon “percolated” back, allowing supplemental extraction.
My only point being that the played out fracked horizontal wells may have a residual value to the investor at a lower break even, the investment having already been depreciated, if more hydrocarbon can be extracted supplementally..
Because net they are guaranteed, by you and me, in the form of bailouts and falling living standards. If not for the work of generations before our time, we would already be Venezuela.
And in case you haven’t noticed, the market is designed to systematically kill all unapproved shorts.
Through oil the crony socialists and capitalists control revenue and costs down to the individual grain. If you employed that 45 handle, you “made” a ton of paper/digital money.
They call it national security imperative.
Net, the empire wins, and the normal distribution never leaves the counterweight, but does a
whole lot of busy work.
There are 60 companies to my knowledge in the oil and gas space that have gone bankrupt and you had to mention Magnum Hunter as your example.
Before the bankruptcy, the CEO of Magnum Hunter, Gary Evans, was emphatically insisting that his company had all kinds of liquidity and kept pointing out the value of their pipeline system that he estimated as being worth half a billion dollars – all this was done to entice equity investors to stay calm and to invest in his stock. When he went into bankruptcy without ever seriously trying to monetize that pipeline system, it was clear that he had no intentions or ability to deliver on his assurances. Talk about a company that threw their equity investors under the bus…
Couldn’t you have picked a company that was actually forced into bankruptcy for your example?
It appears the oil companies and their adjuncts are cutting costs by cutting staff. Two people I know—one who managed the data department at a support company, the other in IT—are looking for work. Both were at the higher end of the salary scale.
The factors behind shale’s ability to continually defy gravity are undoubtably complex. Forgive me for thinking out loud on a conspiracy hypothesis, but given the high stakes power plays in the oil regions from Libya, Syria, Iraq, ISIS, the new relationship with Iran, and the increasing pace of leaks of damning Saudi revelations, I have to wonder if shale has been propped up, least in part, as a hedge against potential Middle East oil flow disruption from these actions. Beyond the financial support of the industry, the regulatory enablements have also seemed to enjoy an irrational sense of urgency and priority for at least the past 8 years. If national policy makers were quietly given some rationale that a productive (if not profitable) shale industry is necessary as part of a national defense strategy, then the regulatory and financial support would seem to make sense. I would assume that the plan was for regulations be eased to enable the production channel to exist and pay its own way, but as the economic realities confronted those assumptions, the industry needed to be propped up by seemingly irrational dark money flows. If the most recent tensions ignite between the U.S. and Saudi Arabia, then shale production may be critical in preventing a national economic catastrophe.
TODAY IS EARTHDAY
NEW YORK, April 22 (UPI) — It’s a first, but is it enough? That’s the question hanging in the air as world leaders from more than 160 nations, including two that produce the most greenhouse gases, sign the Paris climate change accord Friday — Earth Day.
——————————————————————————————-
Right now in the UN HQ in NYC, Sec of State, John Kerry is preparing to join with 160 other diplomatic representatives to begin a planetary policy of decarboninzing the global economy to safer levels in hopes of combating not only climate change in the form of global warming, but also the immediate benefits to scrubbing the air clean of fossil fuel particulate matter which kills millions every year and sickens 10s of millions more, right now.
This fact is not lost on Saudi Arabia, which is building its own solar panel factory, and diversifying its economy to what their own oil minister refers to as the problem of peak demand. In other words, it is only downhill for oil producing nations as economies migrate from first from coal, then natural gas and crude oil. Tesla has over 300,000 paid in cash reservations for its most affordable model, due out at the end of next year. The city of Philadelphia has completed its conversion of buses to a fleet of electric hybrids and now, announced the order for the first 25 all electric buses that will hit the streets soon.
http://www.itsinternational.com/sections/nafta/news/us-dot-announces-latest-projects-for-lo-no-program/
This electric bus program for 7 cities, including LA, from the US Government is a deliberate policy to move all forms of ground transit off of oil, ASAP. None of this is lost on oil companies who will make hay while they still can, storing the oil in the National Petroleum Reserve and parking it on tankers for when prices come to where they would like to see them. A lot of oil will simply be left in the ground, abandoned, not even a stranded asset, because at some point in time, it will be less valuable than the sand on the seashore. Whatever compensation, bonus, exorbitant salaries, benefits, the whole golden parachute, will depend on having the oil out of the ground and ready to ship to a buyer when the time is right. If they don’t pump now, it will probably never see the light of day, which is perfectly alright with me. And being an executive with the skillset of operating in the new harsh environment for oil drillers, refiners, distributors, etc, will come in handy as demand of oil and its by products ratchets downward with each new announcement about the level of electric car sales, electric commercial vehicles and transits, such as the coming fleet of buses. They pump while there is still an industry, while there is still demand and while there is still the hope for a buck to be made just over the ever receding horizon, the new normal for the oil industry in the winter of its life. Too bad it can’t just have a stroke and drop dead now. But, I guess we’ll just have to incrementally walk through the dimension of time with the sequence of events of the here and now to the eventual freedom from a carbon fueled economy in the near future. Patience.
UPDATE: ACCORD SIGNED, PIC OF KERRY HOLDING HIS GRAND DAUGHTER AS HE INKS THE DEAL AT THE UN.
After all, we are all mortal.
http://www.huffingtonpost.com/entry/paris-agreement-signed_us_5717f604e4b0479c59d6ec2f
I will believe it when I see it.
When I drive down (or up) the 405 or 95 I am staggered by the amount of energy used in this country. I look at it and say My Cod how can all of this be replaced.
Both oil and natural gas are used to drive most of the turbines that generate electricity in this country.
I heard all of this 40 years ago!
Of course, I do think at some time petroleum usage will end and then people will probably be living like in 1890!
The human species is bankrupt — morally, ethically, spiritually, logically. Our consumption of oil is destroying the very habitat on earth that sustains all life. We all should know this by now, but we continue cutting off the branch of the tree we are sitting on. We continue talking about oil as a vital resource when actually it is poison, just like Uranium is poison. We are the rapacious killers of nature, and we are suicidal as well.
Are we the stupidest species ever to walk the earth, or what?
there is also the hedges that producers have, that actually pays them the per oil cash price, for a while any way
As you can now see, the only point in going to N Dakota was to pick up welding skill. The banks simply steal the collateral and distribute it to preferred borrowers in the FILO bankruptcy queue, with lots of makework booked as GDP, and growth in crony government.
If you knew someone on the inside and were looking for a structural makework job, you got on at university, where you would learn that the blue and red teams are symbiotic, blaming each other for growth in stupid.
Like all empire choices, the choice between oil, lithium battery, solar, whatever is false. Why would you exchange on form of dependence for another, along with the cost of makework variability?
Do you really think those ciphers in silly valley are more trustworthy?
In ps, you have a ring transfer to a carbon oxygen bond to a carbon chain. Why do you need a moron central control and distribution system serving to maintain artificial RE borders pitting populations against each other as a positive feedback signal?
Rubber on a road is a sad joke, Tesla Motors or no. Your controller should be able to adjust gravity. Your hand doesn’t go through a wall do to like charge density.
Chemistry creates time event horizons.
In a Chapter 11, the debtor has to keep operating if it hopes to have a reorganization plan approved. If it stops operating, no such plan will be feasible, and the company will be liquidated.