Shares in Enquest (LSE: ENQ) are charging higher today, after it was revealed over the weekend that the company is planning a round of cost cuts, in order to protect itself from falling oil prices.
High costs
Compared to the rest of the oil industry, Enquest is a relatively high-cost producer and the company is set to suffer more than most with Brent crude trading below $80 a barrel.
As a result, the company is looking to slash costs, in an attempt to avoid breaking the terms on its bank loans, something the market has been concerned about for some time. Indeed, with Brent crude oil trading below $50 a barrel, City analysts believe that some of Enquest’s existing production is not profitable.
What’s more, analysts estimate that the company’s Kraken heavy oilfield, which is under development in the North Sea, has a projected break even cost of $73 per barrel, making the project uneconomic with oil trading at present levels.
However, Enquest’s management has sought to lock-in profits for the next year by selling forward, or hedging 80% of the company’s production for 2015 at a price above $80 a barrel. So, for the next twelve months, Enquest is unlikely to run into any financial trouble.
Impossible to predict
Still, as it’s almost impossible to predict where the price of oil will be twelve months from now. As a result, it is impossible to say whether or not Enquest will be out of the woods by this time next year. Analysts are especially concerned about the state of Enquest’s £800m revolving credit facility.
The facility was granted with on the condition that Enquest’s debt-to-earnings ratio would stay below the key threshold of 3 to 1 for the duration of the facility. For the six months to 30 June 2014, Enquest’s net debt to earnings before interest, taxes, depreciation and amortization ratio stood at 2.5. Analysts have cautioned that even with 80% of the company’s hedged for 2015, with oil trading below $50 a barrel, Enquest’s debt to earnings ratio will balloon to five times during 2015.
Further, if the price of oil stays low, and Enquest cannot reinstate its hedges at attractive prices, analysts estimate that the company’s debt to earnings ratio could more than double, to twelve times, by 2016. This would be a disaster for Enquest.
Predicting default
Unfortunately, the market seems to believe that Enquest will struggle to survive the next few years.
Indeed, Enquest’s unsecured ten-year 5.5% notes, which trade on the London Stock Exchange’s Order Book For Retail Bonds, are presently changing hands at around 50p on the pound. Additionally, the running yield on the notes has jumped to 18.8% per annum during the past few weeks — because bond yields rise as prices fall. A 50% decline in the value of any bond or note usually indicates that the market believes the company won’t survive long enough to repay the debt.
Falling costs
Nevertheless, Enquest’s drive to cut costs should help improve the group’s financial position. Many of the North Sea’s suppliers are also cutting costs by reducing contractor pay.
So, Enquest is not alone, and industry-wide cost savings should have a drastic effect on costs within the North Sea basin as a whole, giving Enquest a boost.
Overall, Enquest is a risky bet. A low oil price could drive the company out of business but aggressive cost savings could help the group ride out oil market volatility. All in all, if you are thinking about buying Enquest, you need to be prepared for a rocky ride.
