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The Big Oil Problem: It's Going to Get Worse Before It Gets Better

Things keep getting worse for the oil industry. On Wednesday, the price of crude oil dipped below $27 for the second time this year. Earlier this week, officials in both the United States and Europe charged with tracking information about oil supplies came out with intensely negative reports predicting that the glut of oil on the market will only increase as we move through 2016.

And that's not the half of it if you believe local industry analysts who say things are about to deteriorate further. As oil companies gear up to post quarterly reports that are due in a couple of months, analysts say some companies may see the value of their assets cut in half, perhaps even more. 

The oil industry has been dealing with the ups and downs — mostly downs — of the market for more than a year, using all the usual techniques to cut costs and try to survive. It hasn't been enough. There have been thousands of layoffs, and more bankruptcies than we saw in the 1980s oil bust, and the most troubling part is that the oil industry is going to have to take a lot more hits before things begin to look up. In their reports, both the U.S. Energy Information Administration and the International Energy Agency warned that prices are likely to drop even lower this year. In fact, some oil companies are only now feeling the real pinch of the bust as the hedges they'd bought — a sort of "fire insurance" to protect drillers from a bust, according to Ed Hirs, an energy economist with the University of Houston — are ending. 

It's been a stunning reversal of fortunes for many in the industry, Deborah Byers, the Houston managing partner and U.S. oil and gas leader for accounting giant Ernst & Young, says. Drillers in the United States started using slant drilling and hydraulic fracturing to unlock hydrocarbons trapped in the dense brittle shale formations more than a decade ago, but for a long time, the rest of the world underestimated the amount of oil that the shale plays could actually produce. 

So the Organization for Petroleum Exporting Countries — particularly the Saudis — didn't pay much attention when American drillers started tapping into the Barnett Shale in North Texas, the Permian Basin in West Texas, the Baaken in North Dakota and the Eagle Ford in South Texas. The Texas shale plays in particular put United States producers back in the game. After years of declining production that was thought of as a slow fade-out of Texas oil dominance in particular, production began to increase, and eventually it even cut into the market share of the Saudis and other OPEC members. It wasn't cheap to drill in the shale plays, but that didn't matter because interest rates were low and oil prices soared and then held steady at around $100 a barrel.

Right up until they didn't, of course. In June 2014, oil was going for about $107 per barrel, but then OPEC began to flood the market and oil prices started tumbling. Even as prices dropped, people in the oil industry maintained that they would stop before dipping below $50 per barrel, or that they surely would never hit $40, and it was unthinkable that they'd go below $30. 

Despite hopes that oil prices would turn around later in 2016, analysts are increasingly predicting that there won't be a real recovery until 2017 at the earliest. That time frame becomes much more troubling when you consider the fact that this isn't likely rock bottom. After all, some oil companies are still selling their oil for more than twice the current market price because of hedges that are still in place. They've been protected by these deals, but that's coming to an end as oil continues to tank on the market and it gets both difficult and expensive to make new deals guaranteeing a more profitable price, Hirs at UH tells us. 

Oil companies have an option to hedge the oil they're selling by setting up deals in which they will be paid a certain amount of money per barrel in the future. The way it works is they sell oil on the commodities exchange or in private transactions at a certain set price for certain delivery dates. The price you're allowed to set is based on the price oil was selling at when you set up the deal.

This works out beautifully if there happens to be a short-lived decline in the market, because the company gets paid as if the oil were worth $90 a barrel, or whatever the set price is, even if oil is trading at less than half that price. While the downturn has been rough, many companies set up rolling hedges – these hedges can go from 18 months to two years of production — and thus have been able to keep valuing their oil at the higher hedge price for as long as the hedge lasts.

The problem is that many of these deals are beginning to expire. At the end of 2015, 28 percent of U.S. oil companies had hedges in place. That number dropped to 15 percent for 2016 and will drop to just 2 percent for 2017, according to The New York Times.  And because oil prices are currently low, companies are having to go back to their books and start valuing their oil reserves at the going rate, which is in the toilet. Nothing else has changed, but a company is abruptly 50 percent less valuable on paper. That's where the real trouble starts, because these oil companies have credit and loans with banks, but suddenly they can get only half the credit they got before. Meanwhile, companies that were heavily invested in the shale plays aren't pulling in the cash they once were. (This isn't a monolith, and nobody is saying that all oil companies will be affected exactly the same way, but as the hedges expire and oil stays stuck below $30, an increasing number of companies are trying to figure out how to survive. And options are disappearing.)

“They're trying to find solutions. Are these solutions going to be asset sales, recapitalizations, mergers? Those are the only three good options. The bad one is you wind up having to file for bankruptcy. If the bank calls the loan, and you can't pay it back, and you don't have an equity investor willing to come in and backstop, it becomes a liquidation of assets,” Hirs says. “It's one of those things where it can get really bad, and then it will get even worse.” 

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Now we're coming up to the time when companies are going over their finances, with audit teams reviewing the books for the first quarterly earnings reports, and adjusting things to show what their reserves are worth in the current market as the company accountants get ready to submit the required annual reports to the U.S. Securities and Exchange Commission in April. 

Drillers with a lot of debt are also facing credit negotiations in April (the negotiations happen twice a year, once in the spring and once in the fall), and they won't be able to get as much credit because on paper, the main company assets, the oil reserves, aren't as valuable anymore. "Oil prices aren't coming back up anytime soon. If I'm sitting around waiting for oil prices to rescue my company, that's not a very good strategy," Byers says. "Bank regulators are also putting pressure on the lenders because their job is to make sure the banks are healthy. If the banks have huge exposure to oil and gas companies via loans — and they've got $17 billion in loans out to oil and gas companies, in one bank — that's not good."

It's not all doom and gloom for everybody, though. Some investors may see these oil companies filing for bankruptcy and smell an opportunity, Byers says. If investment bankers buy up a company's debt while it's cheap, there's a chance to get ownership of an oil company for next to nothing. “If you do it right and you're lucky and smart, you can end up with an entire company for a very low price,” Byers says. 

At the same time, this is a moment of  enormous stress — and change — in the industry, Byers says. Investors are moving away from putting money into the companies who take risks and explore and find new reserves and will reward companies who play it safe and go with the sure things in the industry. "This is a time of transformation in the industry," Byers says. "The skill set that allowed the risk-takers, the innovative, go-find-it, lease-it-up, put-the-package-together mind-set to be successful is not the skill-set that will allow them to thrive the same way today." 

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