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Getting Ready for Another Round of Commodity Market Downturn

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By Staff Writer on Jul 18, 2016 at 7:30 am EST

Crude oil prices have dropped below the $50 per barrel mark yet again after hitting their highest level in 2016 last month. US crude benchmark, West Texas Intermediate (WTI) is trading at $45.97 per barrel while Brent is trading at $47.69 per barrel in European Markets today. The global crude oil benchmark reached as high as $52.51 per barrel earlier in June.

Although oil prices have recovered some momentum after touching 12-year lows of $27 per barrel earlier in 2016, it still has a lot of ground to gain before reaching summer-2014 levels. Oil market showed some positive gains in June when oil prices crossed the psychological barrier of $50 per barrel. However, it was short-lived as it is currently trading below $48 per barrel.

Will Oil Prices Fall Further?

The downturn, which began in June 2014, has extended for more than 24 months now. Although many analysts and experts had expected the market to recover by the end of 2016, the widening gap between oil supply and demand is showing us a different picture altogether. Crude oil demand from China and other emerging economies have recovered in the past few months, though the growth in crude oil supply has outweighed this increase.

In the past two years, July has been the month that has broken the “bull-run” in the commodity market. For the six-month period ending December 31, crude oil prices dropped by 49% in 2014, and dropped another 38% during the same period last year. The recent decline in crude oil prices have raised concern that the oil-slump will soon enter its third year in the second half of fiscal year 2016 (2HFY16).

Oil Companies: Getting Ready

Amid expectations that oil prices would decline again, energy companies are gearing up to face a long-term downturn. The companies are cutting costs, adding fresh hedges and issuing equity to reduce their debt burden and improve their financial position. They are also divesting non-core assets to shore up their balance sheet and liquidity position.

Hedging

According to the data on Bloomberg, as the 2HFY16 has begun, several oil producers have increased their bets on falling crude oil prices. The oil and gas drilling companies have raised bets on plunging oil prices by almost 29% in 2016.

Moreover, according to the Commodity Futures Trading Commission (CFTC) data, for the seven-day period ended July 12, oil and gas producers increased bets on plummeting oil prices for the third consecutive week. Short bets increased by almost 1.6% during the period.

Hedging has become one of the most important “cash lifelines” for the global oil and gas companies. Laredo Petroleum Inc. (NYSE:LPI) hedged around 2 million barrels of 2017 output earlier in July.

Hedging allows energy companies to not only save their financial position from commodity price risk but also help them avoid bankruptcy. According to the law firm Haynes and Boone, around 85 North American energy companies have declared bankruptcy in the past 18 months. The number is expected to increase further as the global commodity market is not expected stage a recovery anytime soon.

Equity Issuance

Since the start of 2016, several energy companies, including Devon Energy Corp. (NYSE:DVN) and Marathon Oil, have issued common stock to tap the growth of capital markets. According to the data on Bloomberg, international oil and gas producers have raised around $16 billion from the issuance of common equity year-to-date (YTD).

Energy companies aim to use the proceeds from public offering to improve their cash reserve and end their financial woes. Moreover, they also plan to use the cash fund to repay their debt and finance full-year capital budgets.

Spending Cuts, Asset Divestiture

Since the start of the oil slump, energy companies have slashed their capital spending and operating costs by billions of dollars. According to the data compiled by the energy consultancy firm, Wood Mackenzie, more than $400 billion worth of projects have been shelved to date.

The Anglo-Dutch oil giant, Royal Dutch Shell plc (ADR) (NYSE:RDS.A) has lowered its capital spending target for the year to $30 billion. Initially, it had planned to invest $33 billion in energy assets. The company is planning to exit around 5–10 countries while strengthening its foothold in Brazil and the liquefied natural gas (LNG) market.

Other energy companies, including Chevron Corporation and BP plc (ADR) (NYSE:BP), have also lowered their total spending. The companies have delayed and cancelled a number of energy projects and cut thousands of jobs.

Apart from the cost cutting measures, global oil and gas companies have sold their interest in non-core assets to improve their cash flow position and asset base. French oil major, Total has announced to raise $10 billion through asset divestiture between 2015 and 2017, while Shell plans to raise $30 billion during the three-year period ending 2018.

The sell-side firm, Barclays expects spending in the energy sector to increase in the coming months. The research firm is optimistic that oil prices will rebound by the end of next year. However, given the recent commodity market situation, it seems oil companies will not increase their capital and operating expenditure in the coming months. However, we believe if oil prices are to decline any further, energy companies might actually have to implement another round of cost reduction. Asset sales, equity issuance and hedging are also likely to accompany the expenditure cuts.

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