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