Wednesday, February 24, 2016

The Current Debt Crisis

Predictions from various organizations regarding crude oil have a tendency to affect investor sentiment more often than the actual fundamentals that the price represents Most recently, the IEA has projected the faltering of many sources of production in the coming months. As daily pumping wanes, the prices should recover later in 2016 as the stabilization process begins. WorldOil reported that exploration companies have already cut capital investments by 17% off of the previous year's level. The trend should continue as volatility keeps prices in the low $30's going into the end of the first quarter of 2016.

In the United States, oil contracts closed at $32.15 on Thursday still about $7.00 dollars from the closing price of 2016. Brent crude oil closed at $35.07 on the same day trailing its high by $4.00. Iranian oil and a slower than expected drop in U.S. output has caused suppressing sentiment to hold prices around its current trading range. Despite support for an OPEC-wide output freeze and a record gain for crude oil price in late January, stronger bearish volume has countered weak rallies that smell more like short closings than solid reversals.

The price dynamics are interesting, but let's look at fundamentals and balance sheets instead. In the past year and a half, headlines on major financial news outlets have highlighted large spending cuts by oil and gas companies regardless of market capitalization. Reported by the same WorldOil report, a 25% cut in investment spending by Exxon-Mobil, the largest oil company in the U.S., shows the trend that most energy companies are regressing towards because of their vulnerability to the drainage of revenue channels. With about 1,000 rigs stalled, hundreds of companies are forced to find other sources of revenue...or just lose that stream altogether. Because of the loss of capital in the market, billions of dollars of debt are being called into question, and the focus is now shifting from profits to survival. 


An important part of staying on the right side of debt is managing the levels of leverage on which the company operates. The spreadsheet above (available for download using the button in the bottom right-hand corner) looks at the current ratios of the energy companies listed in the S&P 500. These forty companies serve as representative fundamentals for most oil and gas companies. The list includes Chesapeake Energy, whose stock has plummeted because of vulnerability to debt, and Noble Energy, another company struggling with coal and oil prices. Each individual corporation should be looking to monitor their debt levels so that they can survive a period of lower revenue. Doing this prohibits most forms of growth. For example, every extra dollar paid toward interest accruing on a loan cannot be used to discover another underground reserve, Not only is it common sense, but it's an idea that can be used to analyze the trend in expectations that most oil and gas companies will follow. A firm's credit exposure will typically depend on what their own projection for crude oil price is. Bearish outlooks would result in getting rid of debt while bullish outlooks might inspire the opposite. The data above appears to support the former. All but two energy companies dropped their current (short-term) liabilities in 2015 showing the acknowledgment that tough times were here to stay. An average change of 28.6% in the current assets-to-current liabilities ratio accentuates the argument that most firms are predicting low oil prices to stay. Current assets and liabilities are used in this fundamental calculation in order to show changes in leverage inside the next year. Thus, the restriction allows us to look at price trends within the next year. Most firms see reducing debt as a necessity for the next year as all but ten of those listed increased the current ratio which compares solvency levels inside an industry. Eight of the constituents took an even safer route as their current liabilities dropped and their current assets increased. These cautious members accounted for most of the ratio increases with a 77.5% increase among them. Those who saw assets and liabilities both go down only averaged an 18.5% increase in the current ratio.

Despite the variability, the data clearly shows a tightening that is continuing to put more pressure on the energy sector. Less debt means less capital to fuel research, development, and exploration which will inevitably lead to less productivity later in the cycle. The trend analyzed above shows us that firm's expectations for the next year are bearish, and projections for revenue will remain low until a substantial rally is evident. At the same time, there is division in the bearish sentiment with firms that are stocking up on cash (up assets and down liabilities) predicting a long-term supply glut and firm's just reducing debt (down assets and down liabilities) predicting a somewhat shorter glut. Using this knowledge, traders can pick a company that best suits their own projections for crude oil prices. The current ratio measures a company's fundamental balance sheet strength which provides insight on how solvent they can be given an abrupt crash. When the glut starts to slow down, successful companies will utilize their healthy balance sheet by adding more debt to support growth at higher prices. But only then can we know which debt strategy will be the right one.

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