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Why the Energy Sector Could See More Defaulters

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Commodity price drop bites smaller explorers

Financial institutions revalue oil and gas producers’ credit limits twice a year, in April and in October, based on their reserves and underlying assets’ prices. Due to the prolonged weakened oil prices, many oil producers could see their credit lines shrink when they are in dire need of funds. This series will take you to through the implications of historical low oil prices on mounting debts of energy market (XLE) players.

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A major portion of cash generated from operations is getting utilized for repayments of debts as producers are getting ~50% lesser realized prices compared to what they were getting in mid-2014. Therefore, management has little or no cash left for expansion or investments activities. This leads some explorers and producers to borrow more.

Independent explorers and producers seem to be the most beaten down within the energy sector. The chart above shows the price change in the indexes in three different time periods. Explorers like Apache (APA), Pioneer Natural Resources (PXD), and Devon Energy (DVN) have lost 20%–30% of their value in the last one-year period.

According to Haynes and Boone, a law firm based in New York, 80% of oil and gas (UNG) producers will see cuts in their borrowing limits. The credit limit cut will be on average 39%. Debt issued by 168 oil companies is potentially indicating distress.

Credit limit calculation

Banks take two aspects into consideration while lending to an oil (USO) and gas player. They are the company’s reserves and the price of crude. Banks arrive at a probable loan amount by multiplying these two. However, lenders perform very pessimistic calculations, assuming lowered asset prices and attributing little value to upcoming drilling projects.

Indebted E&Ps

According to EIA (Energy Information Agency), net debt to US oil and gas producers more than doubled from $81 billion in 2010 to $169 billion in 1H15. US E&Ps (exploration and production companies) are not generating enough cash even to fulfill capital expenditures. Debt repayments from E&Ps (XOP) for the rest of the year and for next year account for $72 billion and $85 billion, respectively. The default rate for energy companies surged to 4.8% in the last few months and is at its highest level since 1999. The average US corporate default rate is 2.9%.

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