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How Much Oil Goes Missing at $50/barrel?

Keith Schaefer, Editor
Oil & Gas Investments Bulletin
January 6th, 2015

This is the worst time of year for world oil prices to hit a five year low for North American energy producers.

That's because they typically evaluate their reserves at fiscal year-end-and that usually matches the calendar year.  That means reserve evaluations are done with the current price "deck" looking forward (often called "strip pricing") at December 31.

I outline some potential winners and likely losers below, but first make sure you understand what I'm talking about.

Reserves is a very important technical term-it separates all the arm-waving potential oil a company could produce-down to what can be economically produced using the forward "strip".  Most importantly, it is THE thing, the asset, which acts as collateral for their bank debt.

And this industry uses A LOT of debt.

Again, the amount of physical oil in the ground doesn't change because price changes, but amount of economic oil does, and reserves is economic oil.

However, proven undeveloped and probable reserves could potentially decline in size but most important to the bank is the value of these reserves, which are now going (a lot?) lower after this recent oil price move down. 

Reserve reports come in out March or April, based on Dec. 31 pricing. The bank lines, or amount of credit or debt that a bank is willing to lend to energy producers, is based on a company's reserves. And like I said, reserves are the collateral for that debt.

It would be bad news if a company has already used most or all of their existing bank line in the push to boost 2014 production-and then the year-end reserve valuations end up being the same or lower than the previous year.

Banks don't want to lend a higher value than the reserves of the company. So if there is a reduced reserve value, the producer could see their bank line get cut.  And if they already owe more than their newly reduced line, producers may be forced into issuing new shares (which would be done at low, firesale stock prices) or sell assets to cover the portion of the loan called by the bank.

The knock-on-effect would still be felt for the next few months as producers negotiate the future bank debt that will be made available to them.  Investors should ensure they are investing in companies that haven't pushed themselves to the limit of their available debt.

At the very least, the company is unlikely to get any sort of increase to their bank line if there is no material change to their reserves year over year.

That's why reserve reports could be The Next Big Shoe To Drop in the North American energy sector.

In Canada, some names to consider as energy investors head into 2015 are companies like Advantage Oil and Gas (AAV-TSX) and Whitecap Resources (WCP-TSX).  Both have a low debt to cash flow (D/CF) ratios relative to their peers, lots of undrawn capacity on their bank lines and debt is less than 30% of the total Enterprise Value (EV = debt plus market capitalization).

On the flip side, one should be wary of companies like Lightstream (LTS-TSX) and Twin Butte (TBE-TSX) who both have higher D/CF ratios than many of their peers, and debt that's over 75% of EV (90% in the case of Lightstream).

Both companies still have reasonable flexibility with their bank lines now.  But a potential reduction to those lines in the New Year-as a result of lower forecast prices-could put these companies under a lot of stress.

In the US, EOG Resources (EOG-NYSE) stands out as a company in tremendous position with a .0 billion bank line with none of it drawn.  On the opposite side of the equation is a company like Quicksilver (KWK-NYSE) who has a meager $6.7 million of undrawn capacity available on their $2.0 billion of total debt and an EV that is comprised of over 90% debt.

Reserves are impacted the most by the prices for the first three years of production. (Many tight oil wells produce half of all their oil in this time). At the end of 2013, WTI was trading at US$98/bbl (C$105/bbl) with the forward curve sloping down to about US $84/bbl (C$90/bbl) by 2016.

In 2014, WTI finished the year at US$53.27/bbl (C$61.92/bbl) and the futures curve is about US$64/bbl (C$74/bbl) three years out.  What this says is-any reserves from last year that weren't produced in 2014, will now be evaluated at between US$20/bbl (C$16/bbl) and US$45/bbl (C$41/bbl) lower than they were at the end of 2013.  (Note the very different foreign exchange rate from year to year)

So existing reserves will definitely be lower.  Overall reserve growth/decline depends on how much exploration success a company had in 2014.

Things don't look any better on the natural gas side of the equation either.  Canadian gas pricing at Edmonton-AECO-finished last year at C$3.20/gigajoule (gj) with a 2016 price of C$4.22/gj.  While 2014 looks to finish close to C$3.00/gj while the three year forward outlook is roughly C$3.50/gj.

It all sets up some very interesting M&A possibilities for 2015-especially in Q2, just after reserve reports come out.  But in the meantime, investors should be checking the powerpoint presentations of the oil producers they own-to check what percentage of their debt these companies still have available to them.

EDITORS NOTE-Oil prices continue to collapse.  But one energy-related commodity is in a bull market-and is one of the very few stocks I bought late last year.  Short term and long term, time is on my side with this investment. It's how investors accumulate True Wealth that frees up your lifestyle. Start profiting RIGHT NOW.

Originally published:

Keith Schaefer, Editor
Oil & Gas Investments Bulletin
January 6th, 2015

The service we endeavor to provide is to analyze and clarify the nature and potential of certain North American junior oil and gas producers, and identify those situations where the market either misunderstands the nature of the company or assigns unduly optimistic or pessimistic success odds to the company. Keith Schaefer is not a registered investment dealer or advisor. No statement or expression of opinion, or any other matter herein, directly or indirectly, is an offer to buy or sell the securities mentioned, or the giving of investment advice. Oil and Gas Investments is a commercial enterprise whose revenue is solely derived from subscription fees. It has been designed to serve as a research portal for subscribers, who must rely on themselves or their investment advisors in determining the suitability of any investment decisions they wish to make. Keith Schaefer does not receive fees directly or indirectly in connection with any comments or opinions expressed in his reports. He bases his investment decisions on his research, and will state in each instance the shares held by him in each company.

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