The interesting thing about the middle of summer is that there is so little to talk about yet so much to discuss ad nauseum.

From Tom Brady and deflated balls to the collapsing Chinese equity markets to a potential Canadian Federal Election call to Donald Drumpf to GDP to the US Fed to Oil to Iran, it is hard to get a word in edgewise.

Spend hours in a car driving around Alberta as I did this week, with nothing to keep you company but satellite radio and news and sports talk shows, it’s a wonder anyone ever wants to come back to work at all.

One pundit on Bloomberg was explaining to the hosts how oil was headed to the low $30s, while another (or maybe it was the same guy?) was talking about how with all the cutbacks in service costs and fracking efficiencies, that now all of a sudden the breakeven price per BOE for US tight oil was in the low $20’s. Think about it, the companies that were hard-pressed to break even at $100 oil have now, in the space of 8 short months, figured out how to make a profit should the price of the underlying commodity drop to 20% of its peak. Fascinating.

While no doubt a fair amount of hot air, it is indicative about how the discourse about the energy sector seems to be unfolding. Hyperbole trumps reason, the production boom will never end, the Saudis have it in for the Americans. It’s a fair bet that everyone is looking forward to the end of summer when life gets too busy to spend so much time on endless speculation.

Back to a bit of sobering reality.

With a bunch of companies reporting Q2 results and earnings season in full swing, it seems there is maybe no time like the present to revisit a discussion we had several months ago – specifically the debt situation facing the oil patch – what has been called the “debt bomb” by some, and in this instance, it is hard to disagree.

Two data points, courtesy of The Economist and Bloomberg, both debt related.

The chart to the right shows the debt to cash flow for the top 62 US Exploration and Production firms – a standard ratio used by banks to assess risk. You can see the swift expansion of this ratio as cash flows have been eroded by the fall in prices and the amount of debt held by these companies expanded to some $250 billion – what this number basically says is that on average these companies have 6 times as much debt as they have annual cash flow. Of note, this cash flow number does not include capex, which in many cases would make the ratio negative or meaningless since as we discussed previously, most of these companies have negative free cash flow. It’s a Catch-22 for a lot of these companies, the only way to improve the ratio is to improve cash flow, tough in a low price environment. To even maintain cash flow they have to spend capital they don’t have, because the commodity is a declining resource. As the squeeze comes, capital gets more expensive.

Which leads to the second data point. This has to do with the high yield corporate debt issued by energy companies. Since the beginiing of the year, spreads over treasuries for these high yield bonds have expanded dramatically from about 500 b.p. to a current level of 1000 b.p. Put another way, the yield required on high yield energy debt by bondholders is 11.70%, versus 7.40% for the broader high yield index. These spreads are huge and show a big risk premium for the energy sector. Of note – energy represents about 16% of the the high yield index, so defaults in this market will inevitably have knock-on consequences.

Imagine for a moment you are the CFO of a medium sized E&P company facing falling cash flows, expiring hedges, out of covenant bank ratios, declining asset backing because you need to restate reserves, a slowing equity market and need to fund at the very least a maintenance capex program with ever more expensive capital… Hardly a confidence inspiring environment and a situtation that is bound to deteriorate if the weakness in prices persists.

I suppose it’s great and all that some companies might purportedly be able to break even at $20 per bbl, but we aren’t likely to ever find out if it’s true, since the banks will have called their loans long before the theory can be tested. Mr. Smith, it’s the bank on Line 1…

Prices as at July 31, 2015 (July 24, 2015)

• The price of oil was relatively flat for the week as an early China swoon was reversed through the end of the week, but ultimately wasn’t able to hold
  • Storage posted a surprise decrease
  • Production decreased by about 150,000 barrels per day in the Lower 48, but this was largely ignored by the market with the noise out of China.
  • The rig count posted a surprise increase.
• Natural gas held its ground during the week on weather and increased demand

• WTI Crude: $46.71 ($48.15)
• Nymex Gas: $2.716 ($2.778)
• US/Canadian Dollar: $0.7639 ($ 0.7662)

Highlights

• As at July 24, 2015, US crude oil supplies were at 459.7 million barrels, a decrease of 4.2 million barrels from the previous week and 92.3 million barrels ahead of last year.
• The number of days oil supply in storage was 27.4, ahead of last year’s 22.3.
• Production decreased to 9.413 million barrels per day from 9.558 with lower 48 accounting for the decrease
• As of July 24, 2015, US natural gas in storage was 2,880 billion cubic feet (Bcf), which is 3% above the 5-year average and about 26% higher than last year’s level, following an implied net injection of 52 Bcf during the report week.
• Overall U.S. gas consumption increased by 0.5% this week, led by an increase in power-sector consumption of 1.4%. July 28 and 29 saw the two highest days usage of gas for power ever, surpassing July 2012.
• Oil rig count at July 31 was up to 664 from 659 the week prior.
• Natural gas rigs drilling in the United States fell this past week to 209 from 216.
• As of July 27, the Canadian rig count was up to 204 (27% utilization), 119 Alberta (23%), 35 BC (42%), 43 Saskatchewan (33%), 7 Manitoba (41%)). Utilization for the same week last year was 47%.

Drillbits

A lot of reports this week – presented is cash flow from operations or in some cases net earnings for Q2 vs (Q2 last year)

• Husky – Cash Flow for the quarter of $1.2 billion ($1.5)
• Suncor – Cash flow for the quarter of $2,155 billion ($2,406) (includes refining)
• Cenovus – Cash flow for Q2 of $477 million ($1,189)
•  Imperial – Cash Flow for the quarter of $377 million ($999)
• Exxon – Earnings for the quarter of $4.19 billion ($8.78)
• Shell – Earnings of $3.84 billion ($6.13)
• Chevron- Loss for the quarter of $2.22 billion vs net earnings of $5.26.
• Conoco – Loss for the quarter of $179 million vs $2.08 billion profit
• TransCanada – Earnings of $429 million ($419)
• Enbridge – Earnings of $577 ($756)
• The US Fed elected not to increase the Fed Funds Rate at the last FOMC meeting. The market expects a rate rise sometime between September and December
• US annualized GDP was revised up for Q1 to 0.6% and posted a surprise gain for Q2 of 2.3%
• Canadian GDP declined 0.2% in May, the fifth consecutive monthly decline and the longest period of decline since 2008-2009. And this month it was the manufacturing sector that led the decline, not energy