Why We’re About to See More Capex Cuts in the Oil Patch

Due to coronavirus and OPEX+ clashes, oil companies will cut their capital expenditures. Companies such as Husky Energy (TSX:HSE), Arc Resources (TSX:ARX), and Cenovus Energy (TSX:CVE)(NYSE:CVE) have already cut their capex.

Group of industrial workers in a refinery - oil processing equipment and machinery

Image source: Getty Images

If there’s one sector that can’t seem to catch a break in recent years, it has to be the oil patch. The oil industry had a hard time well before the coronavirus pandemic took the global financial market by surprise.

Oil prices became volatile in 2014/2015 amid supply and demand concerns. Then geopolitical spats took oil-producing companies on a wild ride. Many firms had gotten used to climbing commodity prices. They built their operating budgets and capital-expenditure (capex) plans accordingly.

Capex impacts

Broadly speaking, in recent years, companies in the Canadian oil patch have deleveraged, slowed, or pushed out capital spending over longer periods of time. This is due, in large part, to the disproportionately steep decline in heavy oil prices relative to lighter crude produced globally.

This has meant that capex plans for 2020 prior to the dual coronavirus/OPEC+ production disagreement shocks were already cut down from a historical perspective. However, these shocks sent the price of Western Canadian Select (WCS) below US$5 a barrel. This has further impacted the ability of Canadian companies to spend, as they’re currently losing money on each barrel extracted.

Companies like Cenovus Energy, Husky Energy, and Arc Resources have each recently cut their capex budget. In many cases, these companies and others have cut their capex budget dramatically. Oil companies have a few reasons for cutting their capex budget.

Less capital will be spent on production

The first reason that many producers have cut their capex is perhaps the most obvious reason. The reality is that less capital will need to be spent on existing production if companies choose to reduce or shut down production in the near term.

Most of the same companies announcing capex cuts and overall budget cuts have also simultaneously announced near-term production cuts. This is because, in many cases, it’s now more profitable to keep oil in the ground.

Free cash flow

There is another important factor to consider with oil and gas producers. Most companies are valued based on free cash flow (FCF). FCF is a function of capital spending. If companies cut capex to minimal sustaining levels, the hope is that FCF valuation metrics may be less affected, as operating cash flow will undoubtedly be hit hard for most producers.

FCF concerns also feed balance sheet concerns. In particular, the ability for oil and gas companies to service their debt loads and pay dividends is impacted. Money spent on capital investment is money that is not able to be used to pay down debt or pay shareholders a dividend. These are two important considerations for many investors.

Bottom line

In this environment, I expect to see massive and widespread capex cuts in the near term. Markets are moving completely away from caring about production levels. This is because unprofitable production is obviously a detriment rather than a benefit to shareholders. The market is instead focusing on the balance sheet strengths of producers and their ability to survive this economic scenario we find ourselves in.

Stay Foolish, my friends.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Chris MacDonald does not have ownership in any stocks mentioned in this article.

More on Energy Stocks

Energy Stocks

Passive Income: How to Make $137 per Month Tax Free

Canadians seeking passive income each month can go about it in two ways, but you'll need a TFSA and a…

Read more »

A lake in the shape of a solar, wind and energy storage system in the middle of a lush forest as a metaphor for the concept of clean and organic renewable energy.
Energy Stocks

The Future of Energy Storage: Top 3 Canadian Battery Innovators

Tesla has a growing appetite for Canadian battery technology. One among two other top energy storage stocks could reward investors…

Read more »

TFSA and coins
Energy Stocks

Maximize Your TFSA Returns With These Top Canadian Companies

The TFSA can be an excellent choice for a long-term savings account. Here are two top TSX stocks to consider…

Read more »

green power renewable energy
Energy Stocks

Boost Your Long-Term Wealth With These Green Energy Stocks

Investing in clean energy leaders such as Brookfield Renewable Partners can help TSX investors build long-term wealth.

Read more »

Canadian energy stocks are rising with oil prices
Energy Stocks

3 Top Canadian Energy Stocks to Buy Right Now

Three Canadian energy stocks that continue to outperform are the top buys in the slumping sector right now.

Read more »

Oil pipes in an oil field
Energy Stocks

Suncor Energy: The Pros and Cons of Investing in Canada’s Oil Sands

Here's a high-level overview of the advantages and disadvantages of investing in Canada's oil sands with Suncor.

Read more »

bulb idea thinking
Energy Stocks

Vermilion Energy Stock Skyrocketed in 2022: Can It Recover From the Sluggish Start in 2023?

Vermilion Energy stock doubled in the first half of 2022 but has lost 25% so far in 2023.

Read more »

pipe metal texture inside
Energy Stocks

Better Dividend Buy: TC Energy or Pembina Pipeline Stock?

TC Energy and Pembina Pipeline might be oversold. Is one more attractive for dividends today?

Read more »