Economic Report 2016 - Oil & Gas UK

As the basin has become more reliant on debt finance, a number of potential risks to the industry have emerged:

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• Increased chance of financial distress – higher net debt and associated interest repayments mean that businesses are more reliant on steady cash-flows to service agreed debt payments. The preferential treatment of debt means that failure to meet repayments can lead to business failure, even for companies with positive EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation). However, a number of smaller companies on the UKCS that have breached their debt convenants with lenders over the last 12 to 24 months have been able to renegotiate new terms. Banks have, for the most part, supported their oil and gas clients resulting in few bankruptcies to date. The increased reliance on the banking sector, however, does give lenders greater bargaining power when negotiating the cost of new debt. • Increased cost of equity – as debt is treated preferentially to equity (creditors get paid before equity holders in the event of corporate bankruptcy), equity often becomes less readily available and more expensive as investors demand higher returns to take on the greater level of associated risk.

Rising debt levels mean there is likely to be a time lag between any recovery in long-term price expectations and investment in the UKCS.

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• Slower recovery – even if the oil price recovers, companies that have exceeded targeted debt levels will likely ‘cash-sweep’, that is, using excess cash-flow to deleverage by paying off debt rather than reinvesting the returns into new projects. As such, there is likely to be a minimum one to two year time lag between any recovery in long-term price expectations and any recovery in investment in the UKCS as companies prioritise the rebalancing of their financial structure.

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