Rising Interest Rates May Trip Oil Companies

By Bradley Olson Features Dow Jones Newswires

U.S. oil companies have proven remarkably resilient even during a prolonged season of lower oil prices, but a looming threat could limit their growth and profitability: rising interest rates.

Continue Reading Below

A new Columbia University study warns that higher borrowing costs, such as an increase of two percentage points to global interest rates, could essentially erase the efficiency gains that many shale producers have achieved.

That represents a potential problem for U.S. drillers in coming years, as the Federal Reserve ponders gradual rate increases.

"Low interest rates have been a major contributor to the shale boom," said the author of the study, Amir Azar, an energy banker and fellow at Columbia's Center on Global Energy Policy. Higher rates may not "reverse the boom, but it could make a lot of shale production uneconomic."

Most small- and medium-size shale producers rely extensively on debt, borrowing amounts double or triple their annual earnings primarily through high-yield bond issuance to finance drilling operations across the country. Their cost of borrowing goes up as interest rates such as the London interbank offered rate, which is used as the benchmark reference in the study, rise.

Many U.S. companies have sought to address this vulnerability by reining in spending to levels that are in line with costs, something few did when oil sold for more than $100 a barrel two years ago. The new strategy of living within their means, which the industry has termed "cash flow neutrality," has attracted significant attention from investors, but remains an elusive goal for most producers.

Continue Reading Below

Cash has become king for executives wishing to prove their resilience in the face of low prices, and many are likely to focus on the issue this week as earnings season begins in earnest for smaller U.S. companies.

As oil prices remain mired around $50 a barrel, only a few companies have hit the mark in the past year. ConocoPhillips, one of the largest U.S. producers, did so in the first quarter, the company said Tuesday, generating about $500 million more in cash than it spent on new investments and dividends.

"Our focus on free cash flow generation and the lowering of our break-even price is showing up in our financial performance for the third straight quarter," Donald Wallette, chief financial officer of ConocoPhillips told investors Tuesday in a conference call.

Range Resources Co. and Cabot Oil and Gas Corp., two companies that specialize in natural gas production, also generated more cash than capital expenditures in the first quarter.

The largest U.S. shale producer, EOG Resources Inc., which reports next week, kept spending below cash flow for the final two quarters of 2016. Apache Corp., which reports Thursday, did so for the last nine months of the year.

Others who exercised financial discipline last year already returned to spending more. Whiting Petroleum Corp., one of the largest producers in North Dakota, spent about $1.68 in the first quarter for every $1 it took in from operations, according to S&P Global Market Intelligence.

In 2016, they spent 92 cents for every dollar they took in after outspending at nearly a two to one ratio in 2014 and 2015. A Whiting spokesman said that the company generated cash "in line" with its spending in the first quarter when the effects of working capital are excluded.

To make ends meet in the past two years, companies such as Whiting have either borrowed heavily or issued new shares to be able to continue drilling.

While some companies continue to rely heavily on new infusions of cash from Wall Street to make ends meet, the industry as a whole has come a lot closer to balance, according to an analysis last month by Tudor Pickering Holt & Co. A group of almost 50 exploration and production companies, the primary engines of the boom, are set up to outspend their cash flow by about $4 billion this year if oil prices average about $55 a barrel. That is down from about $15 billion in 2016, according to a study last month by energy analysts at Tudor Pickering Holt & Co.

In 2018, the producers are poised to generate more cash than they spend by more than $2 billion if prices are at that level, a sign of dramatic improvement given that before the 2014 crash, most spent $2 or $3 for every $1 they generated from operations.

Mr. Azar said he doesn't foresee a huge production decline even if prices remain low and rates rise quickly. Instead, consolidation is a far more likely outcome, as companies that have generated cash and reduced debt can buy struggling producers, he said.

The impact of higher rates on shale producers may be uneven. Some have reduced debt and hold investment-grade credit ratings, which means their interest expenses would be lower and they are likely to be able to function with less debt.

"Shale is here to stay, and I don't see anything that would stop prices immediately," he said. But higher debt costs will make "a lot of shale production uneconomic for small producers. Then, larger producers will be able to scoop them up."

--Erin Ailworth contributed to this article.

Write to Bradley Olson at Bradley.Olson@wsj.com

(END) Dow Jones Newswires

May 03, 2017 08:47 ET (12:47 GMT)