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The impact of falling oil prices on oil company finances

Hydrocarbon Engineering,

According to Deloitte, the most obvious impact of the oil price collapse on company bank accounts in the increased risk of impairment of assets. Lower oil price forecasts mean that producers should expect lower future profits from an asset. Subsequently, this reduces the present value of the asset, and if the value currently carried on balance sheets cannot be recovered in full, this results in write-off. There may also be a knock-on effect on related deferred tax and holding company investment balances.

Rapidly changing oil prices make it difficult to judge the present value of assets for investment decisions on capital allocation, an acquisition or for accounting impairment purposes. Companies often apply forward curves in their valuation models. Valuation models looks at a range of sensitivities and scenarios. The US$60/bbl oil price that used to be the lower end assumption in models for many companies has now become a reality.

Lower operating cash inflows will inevitably lead to capital expenditure cuts and the potential write-off of exploration assets. In December, when crude oil was trading at US$70/bbl, Goldman Sachs estimated that almost US$1 trillion of spending in future oil projects was a risk.

In addition, reduced operating cash inflows can ultimately result in business failure, so company boards will need to give greater consideration to judging whether the going concern basis of accounting (i.e. whether the company is able to continue trading for the foreseeable future) is appropriate.

Companies may also find renegotiating debt challenging. At times of high oil prices, refinancing existing debt either through bank borrowings or issuing new binds tends to be relatively straightforward. However, lower asset values and increased default risks mean that borrowers will face increasing challenges, including the need to pay higher interest rates or enhance security packages, if they are able to borrow in the first place. The price deck utilised by reserve base lenders (RBLs) may also be reduced significantly, leading to a reduction of RBL facilities and the acceleration of debt repayment schedules, putting even more strain on company balance sheets.

At times of high commodity price volatility, mergers and acquisitions activity can pick up. For example, Ophir has recently made an offer for Salamander Energy, Repsol acquired Talisman in December and there are rumours of other potential acquisitions among explorers and producers. This might be a good time for those with available cash to acquire distressed junior partners, Deloitte highlights. When cash flow problems are present, corporate purchases can take place at bargain prices as a result of investors being forced to exit their investment quickly and realise cash at any price. However, this is rare and only tends to occur in extreme circumstances, as most vendors prefer to hold onto their investment until they get a better offer, if they are not being offered what they consider to be a fair value. When businesses change hands at bargain prices, the purchaser recognises a day one gain on the ‘negative goodwill’ arising in the acquisition and this is recorded immediately as profit (as opposed to positive ‘normal goodwill’ which arises where a purchaser has paid a premium for a business, rather than a discount, and which is carried on the balance sheet).

More companies may also return to hedge accounting, which was increasingly used in the wake of the financial crisis. With prices consistently above US$100/bbl, most exploration and production companies were able to make profits without needing to hedge. However, many companies, especially large players, continued to pay for price hedging instruments. Hedging instruments may become effective for accounting purposes, and companies that have maintained price hedges (for an extended period of taking ineffective volatility through the profit and loss account, companies which adopted a policy of hedge accounting may need to take part of the gains through hedging reserves for the first time in years. For purchasers of fuel such as airlines and bus companies with hedges in place to cap prices, the effect will be the opposite and hedges become ineffective.

Finally, lower pricing leads to high counterpart credit risk where counterparties are dependent on oil prices for cash flow. Where a company is part of a joint venture (JV), there could be an increased risk of JV partners being unable to fund their share of liabilities, including decommissioning costs, and this could result in other partners having to take on their share, putting increasing pressure on their own cash reserves.

Adapted from a report by Emma McAleavey.

Source: Deloitte

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