Despite oil’s recent rally, the harsh operating environment triggered by the collapse in oil prices over the last year has left many companies struggling to survive. Deeply troubled oil producer Pacific Exploration and Production Corp. recently completed a restructuring deal that, while ensuring its survival, virtually wiped out any of the value held by shareholders.

This raises the question as to whether or not the same fate could be in store for investors in heavily indebted Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE). For some time, it has appeared to be close to collapse despite the efforts of management to pull it back from the brink. Even after completing assets sales that totaled $800 million during 2015, there are signs the company may not survive in its current form if the protracted slump in crude continues. 

Now what?

The biggest issue facing Penn West is the potential breach of its financial covenants relating to its debt in the near future.

You see, despite renegotiating those covenants in 2015 to make them more accommodating, they revert back to their original levels by the end of the third and fourth quarters of 2016. When renegotiating these covenants, Penn West, like many in the industry, thought that by the time the covenants reverted to their original levels, the price of crude would have substantially recovered. This has not occurred.

Now, with growing global oil supplies, higher U.S. oil inventories, and the failure of U.S. oil output to fall as sharply as initially predicted, it is unlikely that there will be a sustained rally in crude during the course of 2016.

This means that it is highly likely that Penn West will be unable to generate the cash flow required to meet its financial obligations and ensure that it doesn’t breach its covenants once they revert to their original level.

An additional issue that is exacerbating the risks that low oil prices pose to Penn West is its cash costs of US$20.50 per barrel. This means that even with West Texas Intermediate (WTI) trading at over US$40 per barrel, Penn West is generating relatively thin margins for each barrel that it produces from its existing wells.

A key reason for this is because Canadian crude trades at considerable discounts to WTI. West Canadian Select, or heavy crude, which makes up 14% of Penn West’s oil output, trades at a 34% discount, whereas the discount for Edmonton mixed sweet or light crude, which makes up the majority of its liquids production, is 13%.

The financial pressures these issues are creating are also affecting Penn West’s ability to boost output from its existing acreage through exploration and well development. This is because it has been forced to savagely cut capital expenditures, which has caused production to fall in conjunction with asset sales.

For 2015 total oil production was down by 17% year over year, while 2016 production is forecast to be 26% less than 2015. As a result, revenues are declining, and this is placing even greater pressure on cash flows and Penn West’s ability to meet its financial commitments and not breach its covenants. 

So what?

Regardless of management’s rhetoric, it appears increasingly likely that Penn West will breach its financial covenants once they revert to their original levels by the end of this year. If this were to occur, it may not result in the company’s failure, but it could see its debt restructured in such a way that the value of equity holders will be virtually worthless.

The high degree of risk associated with investing in Penn West substantially outweighs the reward, making it an unappealing investment.

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Fool contributor Matt Smith has no position in any stocks mentioned.