The oil price crash hit the oil sector like a sledgehammer. During the past two years, some of the industry’s most promising companies have collapsed into bankruptcy, producers that previously traded at premium valuations are now penny stocks, and trillions of dollars of oil reserves have been written off.
It’s these reserve writeoffs that are proving to be the biggest issues for small and mid-sized oil producers such as Tullow Oil (LSE:TLW) and Genel Energy (LSE:GENL). Before the crash, these producers use their oil reserves to borrow against, and lenders were happy to comply as the oil under the ground would easily cover the debt owed over the long term.
The big problem with this strategy is that it relies on oil prices remaining at the level where debt is easily covered by asset values. By using this strategy the companies are essentially borrowing from future projected cash flows, if these expected cash flows miss expectations, the whole tower of cards falls down.
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Unfortunately, this is exactly the situation Tullow finds itself in today.
Drowning in debt
At the end of June 2016, Tullow’s net debt was estimated at $4.7bn and unused debt capacity and free cash at approximately $1bn. For the past several years, management has devoted all of the company’s efforts towards the development of the TEN field, which finally began to produce oil on time and on budget during August. Tullow has around 322m boe of proved and probable reserves.
As a rule of thumb, the in-the-ground valuation of proved and probable reserves is around 10% of the average spot price that means these reserves could be worth less than $5/bbl in the ground. If you add in 975m boe of contingent resources, which may attract a valuation of around 50% of proved resources, you get a total valuation of around $4.1bn for Tullow’s proved, probable and contingent resources That’s $06bn below the company’s debt. If this valuation is a worrying sign, there’s worse to come.
Tullow has around half a billion of outstanding derivatives owned as part of its oil hedging programme. Adding these derivatives to Tullow’s net debt sees the firm’s liabilities explode to $5.2bn, nearly $1bn more than the value of the company’s in-the-ground oil.
These numbers are enough to put even the most experienced investor off Tullow.
A stronger balance sheet
Compared to Tullow, Genel looks financially sound. At the end of the first half, the company reported net debt of $237m, with $407m in cash and a free cash flow for the period of $33.1m. Unlike Tullow, Genel has adopted an extremely conservative approach to capital spending and debt management. Capital expenditure has come out of free cash flows and the company has stayed away from building a massive pile of debt to fund expensive projects.
Over the past year, as oil prices collapsed Genel’s net debt has actually decreased by $2m, making it one of the few oil companies that’s improving its financial position in the current environment.
So, as Tullow struggles, Genel is pushing ahead and rather than being worth almost nothing, the market could be undervaluing the company.
