Sometimes the greatest risk facing a company is obvious. That's certainly the case when considering an investment in Whiting Petroleum Corp. (NYSE:WLL). In the company's annual report, Whiting makes clear to investors that its biggest threat comes from oil prices.
Here's how oil prices directly and indirectly impact its operations, which could cause trouble down the road.
No greater risk
Whiting Petroleum leads off the risk factors section of its annual report by saying, "Oil and natural gas prices are very volatile. An extended period of low oil and natural gas prices may adversely affect our business, financial condition, results of operations or cash flows." It then readily admits that it "cannot predict future oil and gas prices," but that the price of oil "heavily influences our revenue, profitability, access to capital and future rate of growth."
The financial impact is quite obvious. Whiting's main source of income is its sales of oil and gas, so when those prices plunge, they take much of Whiting's income with them. That affects the company in the near term as it will have less cash flow to invest on behalf of its shareholders on capex, buybacks, dividends, and acquisitions.
It's all based on oil prices
Whiting also notes that oil prices heavily influence its access to capital. That's because low oil prices could result in a reduction of the company's borrowing base on its credit facility, which is determined by its banks and is based on the collateral value of its proved reserves. The value of those reserves fall when oil prices take a tumble, which could cut off the company's access to credit.
This was a very real risk in the current environment, as the company's proved reserves were valued at $10.8 billion as of the end of last year, but that's based on last year's average oil price of $92.68 per barrel. Now that oil prices are in the mid-$50s, those proved reserves aren't worth nearly as much, meaning the company's borrowing base could be cut as the collateral's value has fallen.
That was worrisome, as the company had $1.4 billion in borrowings out of its $3.1 billion borrowing base as of the end of last year. In order to sidestep any problems, Whiting recently raised $3 billion in debt and equity, which it used to repay all of its outstanding borrowings and boost its cash position. This avoided an uncomfortable position where Whiting's borrowing base was cut below its outstanding borrowings, leaving it scrambling for liquidity.
Oil prices dictate returns
Oil prices also threaten Whiting's ability to grow. It needs oil prices to be above certain levels in order to earn an adequate return on new wells.
For example, in the Bakken shale, the company can earn a 42% internal rate of return on new wells drilled at a $55 oil price, which equates to a 2.1-year payout. That's not bad, but the company's returns would balloon to 82%, and a 1.3-year payout, if oil prices hit $70 per barrel. Meanwhile, Whiting can only earn a 30% return and 2.6-year payout on $55 oil at its Redtail Niobrara position, so drilling there isn't quite as compelling until oil prices increase, as the return jumps to 64% and a 1.5-year payout at $70 oil.
Clearly, weaker oil prices will have an impact on the company's growth rate as it can't recycle capital back into the business quite as quickly at lower oil prices.
The biggest threat facing Whiting Petroleum, or any oil company for that matter, always boils down to oil prices. Those prices impact current profitability, access to capital, liquidity, and future growth rates. The higher oil prices go, the better it will be for Whiting, while weaker oil prices in the future would be very foreboding for the company.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.