United States: Will Oil Prices Drop? What's In Store For The Upstream And Midstream Sectors Ahead

Oil prices hit a seven-month high on Tuesday, with WTI ending the day at $48.31. Prices have been on the rise since hitting lows under $30 in February, with the most recent boost caused by global supply disruptions and Goldman Sachs' higher-demand forecast.

Although prices have rebounded significantly from the February lows, it is questionable that they will rise much further. In fact, Goldman Sachs reduced its 2017 price forecast despite the higher-demand projections, believing that the industry still has further to adjust in the face of record inventories. Moreover, Bank of America Merrill Lynch and UBS reiterated near-term targets below $40, and some market participants see the recent 4½-year high in producer hedging as a negative omen. So, not only does it seem likely that we will see prices come off these levels, it is possible that we could see another sharp decline. For one thing, the temporary global supply shocks that have pushed prices up this year can easily be offset by sustained increase production by Iran and Libya. Additionally, if prices rise further, companies may be inclined to increase production. Either foregoing factor, alongside upcoming refinery maintenance, could easily lead to another supply-demand imbalance and exert downward pressure on prices.

What does all of this likely mean for energy operators and investors in the coming months?

  • The number of Exploration & Production (E&P) bankruptcies will continue to rise steadily. Counterintuitively, perhaps, the current run-up in oil prices has seen a corresponding increase in the number of bankruptcies. In just the past few days, Breitburn Energy Partners, LINN Energy, Penn Virginia and SandRidge Energy have all filed for chapter 11 protection. Quite simply, oil prices have recovered too little and too late to save highly leveraged operators dependent on far higher prices. Many companies have exhausted all viable financing alternatives, and, as high-price hedges roll off, borrowing bases shrink and financial covenants loom, they will find it nearly impossible to delay the inevitable.
  • There will be a comparative uptick in Merger & Acquisition (M&A) activity, particularly asset acquisitions and divestitures. Prices easing higher led to a marked rise in deal activity in recent weeks, and, while a looming price decline may depress deal flow in the near term, overall activity will probably continue to move forward as compared to the last nine months. Previously, divergent price expectations caused a significant bid-ask spread, but, of late, deals have been spurred on by converging price expectations and a narrowing spread. The risk of another sharp decline in prices may certainly cause some consternation; however, it seems that parties are now being more creative and are looking at price protection mechanisms that have not been customary in the industry in order to get deals done.

    The increase in activity will likely be caused not only by various 363 transactions in the context of a bankruptcy, but also targeted divestitures by healthier operators who are still facing some amount of liquidity induced stress, as well as those that have recently emerged from bankruptcy and are looking to unload non core assets. Adding momentum to this uptick are the numbers of newly sponsored management teams eagerly looking for their foundational acquisitions, providing sellers with ample opportunities. Additionally, while A&D is expected to lead the way, there will also be company-level M&A opportunities for stronger operators with well-fitting asset bases and bond prices that would not make for punitive change of control puts.
  • The midstream sector will continue to face commodity price pressure. Recent bankruptcies have highlighted that midstream oil and gas contracts are not immune to rejection. Does this mean that such contracts will be wholesale rejected? Not necessarily. Given the unique nature of many midstream systems and the need for cash flow on both sides, renegotiation rather than rejection and abandonment of the relationship will often be the probable result. Although discussions will be driven by the negotiating leverage of the parties involved, it does seem likely that they will tend to result in economics that are worse for the midstream players in the form of lower throughput fees and reduced minimum daily quantities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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