Challenges Facing the Energy Sector: 2016 Outlook

Where are we now?

It is safe to say that the days of $100 oil are behind us. Oil prices began their descent in September of 2014 and hit rock bottom at the beginning of 2015. The value of natural gas, which is now trading at $2.20, has plummeted 80 percent from highs of $13.50 in 2008. We are experiencing unprecedented rig count decline, with the current nationwide rig count at only half of the prior year level. Capital spending of S&P 500 energy companies is way down from last year and even more cuts are projected in 2016.

What can we expect in 2016?

Hedge roll-offs and spending cuts

Many oil companies have not felt the full financial distress as a result of the rapid decline of oil prices. The reason for this is that many producers have been living on futures contracts, which in some instances, locked in prices exceeding $80 a barrel through the beginning of 2016. These hedged positions kept cash on the balance sheet of many companies and banks from cutting credit supply lines. In 2016, we can expect these income-smoothing hedges to expire, exposing companies to today’s market prices.

“To some degree, through fall borrowing base redeterminations, oil and gas companies are already feeling the effects of their 2015 hedges rolling off. However, banks are being patient with borrowers as long as they can forecast liquidity, which was provided by hedges in 2015,” said Opportune Managing Director Sean Clements. “Next year’s forecasts will be more challenging as hedges are not available to prop up liquidity and borrowing bases are being cut.”

Analysts from IHS Energy estimate that only 11 percent of 2016 North American oil and gas production is hedged which will lead many companies to experience financial hardship and further reduce capital spending. The majority of companies cut spending and capex by at least 25 percent in 2015 and it is expected that another 25 percent of cuts will occur in 2016, even further limiting growth potential in the short-term. In order to survive, companies will be forced to live within their means, resulting in massive layoffs, assets sales, and additional debt if they are lucky enough to find a lender. This paints a grim picture for the industry in 2016.

M&A activity

According to Dealogic, global M&A volume hit a record monthly high in November totaling $606.6 billion, up 7 percent from the previous month and a whopping 70 percent from January of 2014. The oil and gas acquisition and divestiture market is expected to heat up even more in 2016. “Right now, capital deployment through the drill bit is difficult to justify,” said Opportune Managing Director Sean Clements. “The entire industry sees the signs of distress and expects that 2016 will be a buyer’s market filled with distressed assets or assets of companies that are trying to reposition their portfolio to their strengths.  The challenge will be finding assets that work in this market considering the current cost of the next marginal capital dollar.”

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