So, first off, the IHS CERA conference has been on all week in Houston. Called the “Davos” of the energy sector, it has lived up to its nickname, with thousands of well-meaning boondogglers tut-tutting their way around high-end venues hoping to brush shoulders with someone, anyone, that they can pass a resume to and get a job. Wait a second, it’s not a job fair? Then why are there so many people who aren’t meaningfully employed in the sector in attendance? Honestly, do I really need reporters from multiple Canadian news outlets giving me a daily update from the conference when I can get up to the second pithy observations from the Twitterverse?

My point? Nothing really comes out of these conferences. OPEC said they were talking about a freeze – we knew that last week. The IEA is sounding the alarm on under-investment in the patch – we knew that. Saudi Arabia says they aren’t going to cut production… yet… and the rest of the world needs to get their costs in line or it’s lights out… nothing new here.

Even the market pretty much shrugged off all of this commentary, preferring to look at, heaven forbid, some fundamentals, like production, income statements and balance sheets.

This conveniently brings me around to what has been and is increasingly a critical issue in the oil patch right now – balance sheets and what to do about all the cheap debt that energy companies have amassed over the last number of years to finance their exploration activities (and as we have seen previously, with many generating massive amounts of negative free cash flow at $100 a barrel oil, never mind the balance sheet carnage at $30).

How much debt?

According to the Bank for International Settlements, bonds outstanding for energy companies rose from $455 billion in 2006 to $1.4 trillion in 2014 and syndicated loans to energy companies increased from $600 billion to $1.6 trillion in the same period. The BIS says that the US accounts for about 40% of the total.

It sounds pretty dire, and it is, with one caveat that this is debt for “energy” companies – up, mid and downstream and includes NOCs as well, so it’s not like all that debt belongs to Chesapeake, although some days it seems like it.

The real problem is the interconnectedness of all that debt and the risk of default – expressed as spreads vs risk-free fixed income and bank provisions – as the natural deleveraging that follows the deflation of an asset bubble proceeds, and will this be an orderly process or a rush to the exit?

In the US or more broadly, North America, there is a significant amount of debt in the tight oil and shale gas explorers who have been among the hardest hit in this downturn and this is having a major impact on the broader lending market. With spreads on all junk bond sectors expanding rapidly investor are getting the jitters.

A Bloomberg report recently pegged the amount of outstanding oil and gas bank loans to domestic producers at $123 billion (interestingly about the same as the sovereign debt of Venezuela). While the loans amount to a small proportion of the banks’ portfolios, a high percentage of these loans (about 45% on average) are below investment grade or unrated, raising the vulnerability.

With the debt exposure so high and capital availability from previously profligate lenders dried up, oil and gas companies are doing all they can to honour their debt obligations.

But the solutions to this massive deleveraging are few and not a lot of them are of the short term or painless variety. Each has its price.

The first and typical step is to cut costs and lay people off – this has already happened and much of this represents one-time gains that are hard to replicate in future periods in a material fashion, so any further improvement becomes mostly incremental. The slash and burn approach has a downside as well in that as the downturn continues, the hollowing out of the industry makes it harder to recover with prices because your human capital has been sacrificed to pay the bank.

The other solution is to produce as much as possible and sell your product forward through a hedging program until prices rally. This works for a while, except that if financial constraints keep production levels high and result in increased hedging of future production, the addition to oil sales likely magnifies price declines. In the extreme, a downward sloping supply response of increased current and future sales of oil could amplify the initial decline in the oil price and force further deleveraging. One need only look to “continued resilience in US production” for what this means.

Alternatively, you can lower capex, which was funded by debt anyway since most of these companies have no cash flow of significance to reinvest. This is indeed happening, with capex for 2016 down significantly. But unfortunately what this means is that as decline rates catch up and reduced cash flow, it becomes harder to make those payments.

Another option is asset sales, however the M&A market has yet to truly pick up steam and selling assets to make debt payments (as Chesapeake recently did to meet a $500 million obligation) is a short term measure that can only be done a limited amount of times before it becomes self-defeating.

As we approach the end of Q1 and the reset of a lot of bank lines happen, we are seeing a final option finally happen.

Companies have been selling near record amounts of equity in the first quarter. In a Bloomberg article recently published this equity bubble was extolled as being indicative as “hope that the worst is over”. Respectfully, I do not concur. It may be over for the healthier companies, but it is not a reflection of optimism but rather the latest step in the deleveraging process. This is new equity is not fresh capital to put into the ground, it is intended to plug the holes in balance sheets, diluting existing shareholders and getting it done before the bank ratchets back your loans by another 25% or worse yet, issues a demand notice – which likely leads to the final, final option – a bankruptcy filing.

Of course while the North American situation is of particular interest to us, it is important not to lose sight of what might be an even bigger catalyst that would accelerate the deleveraging that is happening, specifically, the risk of sovereign default.

The key countries at risk and to watch are Venezuela, Azerbaijan, Nigeria and, to a lesser extent, Iraq and even Russia.

In the case of Venezuela, default increasingly appears to be a matter of when, not if, given the disastrous economic fundamentals, the political turmoil, the emergency economic measures being implemented and the prospects for the energy industry.

For a country so dependent on foreign cash to keep running, Venezuela faces a mounting, existential crisis. The country has $120 billion in sovereign debt with $10 billion in payments due this year. Exports are expected to generate less than $18 billion this year, inflation is running at 700% and the currency is collapsing. PDVSA, the national oil company, is slashing investment and production and hard currency receipts are declining. A default shuts off any remaining access to capital and could lead to a significant downturn for the domestic energy sector, this in a country with the highest reserves in the world. (Ironically, a default-induced collapse of the energy might perversely accelerate a price rally in oil).

Not to be outdone, other countries are lining up for aid as well including both OPEC and non-OPEC parties. These include Azerbaijan (up to $4.0 billion from the IMF), Nigeria ($3.5 from the World Bank), Ecuador, Kazakhstan, Iraq (already received $1.5 billion in emergency funding) and to a lesser extent Russia and Angola. Not to mention the fiscal pain being endured by the more stable Middle East producers.

This is not to say a global collapse is imminent, but as we have seen in previous crises related to asset bubbles and subsequent deleveraging, all it takes is for one catalyst to go and the daisy chain is easy to follow from Venezuela to Wall Street to Odessa, Texas to Fort Nelson, BC. The risk is real.

Prices as at February 26, 2016 (February 19, 2016)

• The price of oil ended the week up
  • Storage was up, finished product inventories remain high as refinery turnaround season is in force
  • Production was down
  • Markets continue selling the storage story.
  • The rig count decreased significantly
  • The market is anticipating eventual OPEC action
• Natural gas fell during the week on warmer weather and low draws.

• WTI Crude: $32.98 ($29.90)
• Nymex Gas: $1.787 ($1.811)
• US/Canadian Dollar: $0.7398 ($ 0.7261)

Highlights

• As at February 19, 2016, US crude oil supplies were at 507.6 million barrels, an increase of 3.5 million barrels from the previous week and 83.5 million barrels ahead of last year.
  • The number of days oil supply in storage was 32.4, ahead of last year’s 28.1.
  • Production declined for the fifth consecutive week and was down to 9.102 million barrels per day. Production last year at the same time was 9.242 million barrels per day. The decrease in production this week came from the Lower 48.
  • Imports continued at elevated levels during the week
• As at February 19, 2016, US natural gas in storage was 2,584 billion cubic feet (Bcf), which is 29% above the 5-year average and about 31% higher than last year’s level, following an implied net withdrawal of 117 Bcf during the report week.
  • Overall U.S. natural gas consumption decreased by 19.7% for the period led by residential consumption.
• Oil rig count at February 26 was down to 400 from 413 the week prior.
  • Rig count at January 1, 2015 was 1,482
• Natural gas rigs drilling in the United States were up to 102 from 101.
  • Rig count at January 1, 2015 was 328
  • The continuing massive decline in U.S. rig counts continues to be a somewhat overlooked story given all of the OPEC related noise
• As of February 23, the Canadian rig count was at 160 (23% utilization), 102 Alberta (22%), 34 BC (41%), 22 Saskatchewan (18%), 2 Manitoba (13%)). Utilization for the same period last year was about 48%.
• Offshore rig count was up to 27
  • Offshore rig count at January 1, 2015 was 55
• US split of Oil vs Gas rigs is 80%/20%, in Canada the split is 47%/53%

Drillbits

• More companies reported their Q4 and full year 2015 numbers. Of note with many of these companies is the significant declines in capex. Many are reporting lower production numbers year over year in a sign that low prices are finally forcing production declines
  • Husky reported a loss for Q4 of $69 million and cash flow of $640 million compared to a loss of $603 million and cash flow of $1,145 million for the same period last year
  • Encana reported a loss of $612 million for the quarted versus a gain of $198 million in the same period last year. Impairments of $512 million were taken in Q4. In addition, the company underlined its aggressive and successful cost cutting intitiatives as well as announced a further 20% reduction in its workforce, which will leave Encana with about 50% of the staff it had in 2013.
  • Apache reported a loss of $7.2 nbillion for Q4 including $5.9 billion in impairments and a full year loss of $23.1 billion and cut capex by 60% from 2015 levels.
  • Altagas announced net earnings for the quarter of $54 million compared to a gain of $10 million in the same quarter last year. Adjusted earnings and EBITDA were considerably higher. In addtion, the company announced it was abandoing its DOuglas Channel LNG facility, citing an inablitiy to secure purchase contracts in the current environment.
  • Halliburton announced a further 5000 job cuts
  • Chesapeake reported a net loss for the quarter of $2.23 billion and $14.86 billion for the year. Capex is to be cut by 57% and the company is expecting to sell an additional $0.5 to $1.0 billion in assets this year.
  • EOG reported a fourth quarter loss of $284 million compared to net income of $445 million last year. Capex is expected to be about 50% less than last year.
  • Enerflex reported a Q4 loss of $33.5 million compared to a profit of $32.5 million last year. In addition, the company announced a reduction in its workforce of 1100 people compared to the same time last year
  • Trican reproted a loss for ther quarter of $302.5 million compared to a gain of $11.9 in the same qurter last year. Staff count after the sale of its US division is now 75% lower than last year
  • Calfrac reported a net loss of $141 million for the quarter.
• Attention Canadians: The facility, pictured to the right, is what a completed LNG export facility looks like. The Sabine Pass LNG terminal constructed by Cheniere energy in Louisiana is the first to be constructed in the Lower 48 and shipped it its first cargo of domestic LNG this past week. It is to be joined by 4 others currently under construction which when completed will give the US a combined export capacity of about 9.2 Bcf per day or 13% of total US production and just under double Canadfian marketable production. Meanwhile, the LNG industry in Canada continues to flounder on FID watch and regulatory uncertainty.
• Drumpf Watch – Donald Drumpf won both South Carolina and Nevada. Not one candidate is standing out. Chris Christie has endorsed the Donald, no doubt looking for a job. Super Tuesday is upcoming. Ted Cruz should win Texas and Marco Rubio needs to get competitive in a hurry to extend this fiasco another month or so, but unless the people that make a difference (voters) get their heads out of … the likelihood of a Drumpf nomination is expanding rapidly. It should be noted that this absurd Black Swan Event did not need to happen.
• For those who are interested, my year end fearless forecast portfolio is up a modest 0.76% compared to the TSX Capped Energy Index of -7.80%