The clock is ticking for many oil companies, and each day that passes with oil below $50 probably sends a shiver through the spine of oil executives that are carrying some extra weight on their balance sheets. It is a chill that will only grow colder as summer turns into fall, because fall brings a very important decision from their banking group. That decision, which comes each spring and fall, is a redetermination of the line of credit the banks are willing to extend. With the price of crude not showing much improvement over the past six months, it's growing all the more likely that banks will turn a cold shoulder on oil drillers this fall and cut deep into the credit lines they'd been extending.
Of falling oil and credit lines
The bank credit facilities of oil drilling companies are based upon the value of their oil and gas reserves. Given that prices remain weak, the value of the oil and gas assets backstopping bank credit lines are now worth much less than they were just a year ago. This suggests that banks will likely reduce the credit lines they've extended to drilling companies to reflect the current commodity price environment.
There's just one problem with this scenario, many oil companies relied heavily upon those bank facilities for their short-term funding needs. Others boasted of the huge stockpiles of liquidity that they had thanks to the remaining borrowing capacity on their credit facilities. However, should banks dramatically reduce those facilities it could create a real credit crunch for oil companies as early as next month. In fact, some analysts on Wall Street are expecting banks to reduce borrowing bases by as much as 15% this fall. That could erase upwards of $10 billion in liquidity from the energy industry at a time when liquidity is at a premium.
Making preparations and hoping for the best
The concern with analysts and investors is that banks could cut much deeper than anticipated. This is one reason LINN Energy (NASDAQOTH:LINEQ) has been so badly beaten down this year: It's been very liberal in using its credit facility having borrowed $3.75 billion. LINN Energy has already seen its capacity cut this year as it had a $4.5 billion borrowing base before its credit facility redetermined in May to $4.05 billion, while its Berry Petroleum subsidiary had its borrowing base reduced from $1.4 billion to $1.2 billion. The net result of these cuts left the company with $1.5 billion in remaining borrowing capacity. However, that liquidity is expected to further dry up this fall as LINN Energy expects its banks to cut another $500 million from that facility leaving it with about $1 billion in liquidity. The concern, though, is that its banks cut even deeper than that, potentially cutting the facility below its outstanding borrowings thereby forcing the company to quickly repay any overage.
While that scenarios is unlikely as LINN Energy does have a pretty good cushion at the moment, it could still face some trouble in the future if oil prices do stay lower for longer. Some of its other peers, however, are much closer to the edge and could go over the cliff as early as this fall if banks are stingy. Such a move could force these weaker players into either distressed sales or joining the lines at the bankruptcy court.
Of the two, the more likely outcome of this fall's redeterminations is a rush of asset sales at what could very well be distressed levels. We've seen a trickle of these deals in recent weeks as drillers have started to shed midstream assets or non-core conventional oil and gas assets. However, when push comes to shove we could actually see a few more mergers or larger asset packages changing hands. Companies simply won't have any choice as they'll need the cash to relive the pressure from their banks.
The oil industry could be in for a rough fall if banks turn a cold shoulder on them and really cut deeply into their credit lines. Oil companies like LINN Energy are already planning for steep cuts and believe they are safe for now. However, some companies might see their lines cut deeper than expected, which could lead to a wave of merger and acquisition activity as oil companies scramble for cash, or in a worst case scenario we could see a few more bankruptcy announcements. It could be a very cold fall for the oil patch.
Matt DiLallo owns shares of Linn Energy, LLC. 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.