Risk factors in oil and gas

But what do these consequences actually look like? To develop a better sense of the true cost of the price decline, BDO also looked at the financial performance of more than 300 publicly traded middle market oil and gas companies from around the world for our second annual Global Energy Middle Market Monitor. The study analyzes companies' revenues, profitability, debt ratios, and more to glean a holistic picture of the health of energy industry. This year's assessment reveals substantial revenue losses, overwhelming debt burdens, and wavering investor confidence.

The data points to a difficult road ahead for oil and gas companies. Not only must prices remain stable (or ideally, increase further), companies must also dig themselves out of financial holes, reassure skittish investors, and streamline their E&P activities to right the ship and navigate toward growth and prosperity.

GRAPPLING WITH FINANCIAL OBSTACLES AND INVESTOR ANXIETY

According to the Middle Market Monitor, year-over-year changes in median annual revenue highlight how hard the price slump truly hit the global energy sector in 2015. Median revenue across all companies assessed fell by about 30% -- from $96.9 million in 2014 to $67.6 million in 2015-and as revenues have slipped, so have profits. Globally, median pre-tax income declined from $5.9 million in 2014 to a net loss of $30.2 million in 2015. After taxes, net income dropped from $5.1 million to a loss of $30.5 million-a seven-fold decline.

Investors have begun to sour on middle market oil and gas companies as a result. The median market cap across all companies studied dropped to $91 million in 2015 from $219 million in 2014, a 58% decline. At the same time, historic price-earnings (PE) ratios took a hit, with the median historic PE ratio falling to 6.4 this year from 12.4 last year and from the five-year high of 25.6 in 2010. And as margins and investor confidence have slipped, oil and gas companies have struggled to secure capital to keep their businesses afloat with the median debt ratio growing by nearly 25% this year.

These factors create a troubling financing picture for oil and gas companies. It is no surprise, then, that 96% of companies studied in this year's RiskFactor Report point to a lack of capital or credit and their indebtedness as a risk, the highest proportion in six years. The increasingly tenuous financial situation of many companies has amplified associated risks, as well. The threat of bankruptcy has more than doubled, from 8% in 2015 to 19% in 2016, and with dozens of E&P companies already declaring bankruptcy over the past 18 months, it seems likely that more will follow.

Meanwhile, this year's RiskFactor Report shows a substantial uptick in the number of companies citing a downgrade in credit rating as a potential risk: 38%, up from 25% in 2015. This risk has impacted companies of all sizes. Not even the Supermajors are immune, with Moody's downgrading the credit ratings for Chevron, Shell, and Total in April 2016. Companies are not only concerned about their own credit, four in five worry about the risks associated with their hedging arrangements, and 71% cite the creditworthiness of their hedging counterparties, vendors and partners as a risk.

The financial challenges have, inevitably, also affected companies' exposure to accounting-related risks. As prices dropped throughout 2015, many companies were forced to write down the carrying value of a number of their properties, leading 84% of companies analyzed to specifically note risks associated with financial reporting, accounting methods and impairment this year.

REINING IN EXPLORATION AND PRODUCTION

As prices have continued to plummet, numerous upstream oil and gas companies have put the brakes on additional exploration and production activities. According to Baker Hughes' international rig count for May 2016, the total number of rigs in operation declined by 203 from May 2015 levels-and this decline is reflected in companies' expenditures on E&P.

Overall, the Middle Market Monitor found median exploration costs have decreased significantly, from $36.2 million in 2014 to just $7.9 million in 2015, a 78% year-over-year decline. It becomes clear how aggressive these exploration cuts have been when we examine exploration costs' median share of overall revenue. Globally, the median exploration cost as a percentage of revenue declined by about half, which far outpaces the 30% decline in median revenue discussed earlier.

While middle market oil and gas companies were quick to cut exploration, they were slower to curtail production. We've even seen production grow in select markets. Median daily oil production grew by 14% in Canada over the past year, and 25% in the United States, which suggests many companies sought a continued source of cash flow-even if that source produced rapidly diminishing returns.

However, total production costs declined in three of the four major markets analyzed by the Middle Market Monitor: Canada, the UK, and the United States. Production costs did tick upward in Australia, but given that Australia's oil and gas markets tend to lag behind those of the other major oil-producing countries, it seems likely like their costs will taper off in the next six to 12 months as well.

Despite efforts to curtail production, the industry remains deeply concerned about its ability to find and replace reserves. According to the Middle Market Monitor, median reserves fell 35% year-over-year, and reserve replacement ratios were sliced in half (though the median replacement rate remained a more-or-less healthy 101% in 2015). Median reserve additions were down a whopping 94%.

The RiskFactor Report reflects the anxiety the industry is experiencing around reserves, exploration and production: The year 2015 marked the first time that 100% of the companies analyzed cited supply risks in their annual reports. In prior years, this risk was driven primarily by competition as more and more players sought to enter the shale game, as well as by the short-lived nature of shale plays, which tend to deplete more quickly than conventional reserves. But this year, supply risks have been characterized by worries about the financial feasibility of securing new reserves and the necessity to shed assets that are no longer economically viable.

Inaccurate reserve estimates also continue to plague E&P companies, with 93% noting this as a risk in their 10-Ks, a small increase from last year. Again, though this risk is likely to persist in both high- and low-price environments, it takes on a particular urgency this year as companies struggle to forecast what lies ahead for the industry and their own businesses.

LAYING THE FOUNDATION FOR RECOVERY

So, what can middle market oil and gas companies do to weather the storm and prepare for a more stable future? While it will ultimately vary by market and circumstance, companies have a number of options at their disposal:

Seek opportunities to diversify. Companies that have the resources to explore different facets of the industry-whether that means opportunities in natural gas production and exportation, midstream infrastructure, oilfield services, or completely different segments of the natural resources space-should consider doing so.

Consider alternative funding sources. Thought debt financing may be drying up for many companies, other capital providers remain interested. Going private may be one option; private equity buyers have been eyeing the oil and gas industry since the start of the price slump, carefully watching valuation trends and seeking out companies with the potential to survive the downturn and emerge profitable when prices rebound. In some countries, government funding might be an option, as well.

Evaluate hedging arrangements. In 2014 and early 2015, many companies benefitted from the hedging contracts they locked in while oil prices were still high. Though those contracts eventually expired and could no longer protect companies from the price crash, companies should closely monitor oil prices and consider entering hedging contracts now that prices are at a more reasonable level.

Slim down. Many companies have already begun the painful process of making cuts across their businesses, from selling non-core assets to implementing layoffs. But the key is being as strategic as possible when making these cuts. No company wants to be left behind when the industry turns around and leaves them scrambling for skilled labor, access to pipeline and refining infrastructure, or customers.

Continue to prioritize innovation. Though innovation may require significant upfront costs, it can result in major cost reductions or production improvements down the line. Companies should explore options for financing or offsetting the costs of innovative research, such as tax incentives for research and development activities or government grants/contracts.

Explore restructuring options. While bankruptcy and restructuring regimes vary by country, these may be a viable option of last resort to help distressed companies settle their debts and turn around their businesses. While such arrangements may generate significant near-term pain, they may also help position struggling businesses to grow in a more favorable economy.

ABOUT THE AUTHOR

Charles Dewhurst ([email protected]) is partner and leader of the Natural Resources practice at BDO USA LLP.

For more information, read the full 2016 BDO Oil & Gas RiskFactor Report and 2016 BDO Global Energy Middle Market Monitor.