2015 was a year marked by a dramatic reversal of fortune for the oil industry. Crude oil prices dropped down to a third of their 2014 highs, effectively pouring ice water on America’s shale revolution.
To understand what many oil companies have been going through in the last year we need to enter a dark forest filled with hedges, zombies and strippers.
Hedging is the process whereby investors will pay oil companies ahead of time for the oil they are going to drill, at a fixed rate. Steve Trammel, Director of North American Well and Production for IHS, said a common hedge offered toward the end of 2014 could have been $55 for each barrel of crude oil a company would produce for the coming year. Oil was selling for more than $60 dollars a barrel at that point, so this would be a pretty good deal for investors.
“Think about gambling,” Trammel said. “Really, that’s what it is.”
The gamble on the investor’s side was that prices were going to go up, so they would make even more money selling the barrels they’re buying from the producer at that fixed $55 rate.
Hedging like this was happening a lot at the beginning of 2015 because investors didn’t think oil prices would actually keep falling. But they did, down to $45, $40, even $35 per barrel.
Initially, this would be good for the producers, because the investors still had to pay $55 per barrel. But, according to Trammel, many of the investors decided not to hedge again in 2016 after their bet went the wrong way. All of a sudden these companies with hedges will have to sell oil at the real price and that could be a problem.
Trammel said the cost of drilling non-conventional wells can range from $2 million to $8 million per well. Many small and medium sized oil companies don’t have that kind of money in the bank, so they took on a lot of debt. The Financial Times reports U.S. oil and gas company debt more than doubled from the end of 2010 to June 2015.
But, toward the end of 2015, the money many production companies were bringing in with oil sales was only enough to pay off the interest on that debt.
These wells just paying off interest and slowly cannibalizing company resources are at times referred to by those in the industry as zombies.
Managing Partner at Ponderosa Advisors Bernadette Johnson provides consulting services to oil and gas companies. She said another problem facing producers in the low price environment is having too many so-called stripper wells among their assets. Stripper wells are legacy wells which may have been producing oil for 20 to 40 years. They still cost money to run, but not much oil is coming out of them any more.
“If you’re a company that has a lot of those and you’re in the red,” Johnson said. “You’re going to have to abandon them, you’ll have to file for bankruptcy.”
Granted, this is a doomsday scenario, but it happened to more and more companies as 2015 went on. Law firm Haynes and Boone tracks this and they count 41 oil and gas bankruptcies from January to the middle of December. Both analysts, Bernadette Johnson and Steve Trammel, expect that trend to increase in the New Year. That means more layoffs, fire sales and mergers.
Trammel believes a barrel of oil will be cheap through at least the first half of the year, due in large part to Iranian oil coming back onto the market. Iran being able to export its oil was part of the nuclear deal signed with the U.S. and other world powers in 2015. Trammel said Iran will be able to move their barrels fast.
“I’ve heard that they have oil on ships just sitting there waiting,” he said.