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In today’s tough price environment where most oil and gas juniors are losing money, a strong balance sheet is the key to survival, says Brian Bagnell. Access to liquidity will also help these companies hold on until prices rise again. Bagnell, a research analyst for Macquarie Capital Markets, tells The Energy Report he expects a gradual turnaround to begin late this year, and gives his tips on identifying companies that can weather the storm.
The Energy Report: Brian, is there a production cost for North American oil and gas producers at which most juniors can no longer afford to operate?
Brian Bagnell: When you’re losing money—and at these prices, most companies are—the balance sheet becomes the most important asset you have. We have a number of producers that have balance sheets that are looking stretched on the current strip, but there are also a number that are doing fine, either through a combination of hedging in 2016 or conservative capital budgets in 2015 and 2016, which has left them in relatively good shape looking forward into 2016.
We did a study last month looking at break-even costs for all of our North American producers. We looked at 57 covered companies between Canada and the U.S. When the 2016 strip was hovering around $41 per barrel ($41/bbl), we found that the vast majority of companies were able to cover production costs. However, once you consider maintenance capital, which is money that needs to be spent by the company to hold production at current levels, only 9 out of 57 had excess cash flow. Once we factored in dividends, that number dipped to just three companies.
TER: How do you identify a junior company with staying power in this price environment?
BB: Again, the focus should be on the balance sheet because if a company is losing money the key plank to staying power will be its access to liquidity. So it just becomes a matter of how long a company is able to sustain this current downturn. The strength of the balance sheet is going to determine whether a company is able to hold on long enough to take part in a gradual increase in pricing.
TER: What will stabilize the market?
BB: It’s a matter of supply coming offline. There are data points that help us to believe that demand for crude will continue to grow, but the key plank is going to be a reduction in supply. There are too many companies in the world right now losing money. Not all of them are going to make it. Not all of them are going to be able to sustain their current levels of production, which means production gets shut in or is allowed to decline. That also contributes to shrinking the gap between supply and demand. Our team thinks that the global supply/demand equation will start to come back into balance later this year.
TER: What would trigger a gradual price rise toward the end of this year?
BB: Aside from some event such as increasing tension in the Middle East or an emergency OPEC meeting resulting in an agreement to reduce production, it’s just going to be a matter of supply declining or being shut in. It’s not something that’s going to happen all at once. It’s going to be a slow response in companies shutting in wells or letting production decline.
TER: Are companies still shutting in?
BB: There hasn’t been much shut-in activity in North America to date, even with the prices of crude where they are. You get into a bit of a tough situation with deciding to shut in production. If you shut in production, your cash flow will decline. As your cash flow declines, you’re less able to maintain even a lower level of production and your costs per unit of production can increase. So it can become a bit of a downward spiral, though this is a bigger issue for companies with higher-than-average leverage.
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