Debt is a major problem in the oil sector. And should be taken seriously. For Premier Oil debt, has grown over time.
That debt now accounts for 3.3 times of revenue because it hasn’t kept up because of the weakness in oil price market.
With that level of debt, retail investors should expect further share price dilution through a Rights issue or from more borrowing.
Debt growth vs. Asset growth
So, why couldn’t Premier Oil stop spending when the oil price turn unfavourably?
One reason is to build up reserves to sustain the increase in annual production. The other is long-term contracts agreement because developing oil fields take years.
This is why the cost of assets (tangible) in Premier Oil is more than 14 times greater (see blue bar), then it was back in 2006.
The novice investors looking at Premier Oil’s balance sheet would see no increase in tangible assets as they focus on its net book value.
But behind the scenes, they miss the rise in original costs of these assets (see the blue bar chart), which is the cause of capex spending. At the same time, impairments were building up causing accounting losses.
In fact, these impairments have devalued the cash-generative assets to 32% of its original value down from 66%, a decade ago.
However, the opposite can be true if oil price return back to $80-$90, therefore, bolstering accounting profits while net cash flow decline.
Too much debt makes it hard for Premier Oil to meet Interest Costs
The only reason investor see debt grows is because it will bolster the company’s revenue and profits by taking advantage of higher rate of returns from investment. And higher profits are necessary for paying off higher interest costs.
For Premier Oil, that relationship broke down. With long-term contracts already agreed and signed, Premier Oil was generating less cash and therefore needed to borrow more than expected to meet their contract commitments. The chart below display this relationship perfectly when debt overwhelms adjusted operating profits (see red bar chart) from 2014 onwards.
If you show adjusted operating profits as % of total debt, it went from over 100% to 5%. That means adjusted operating profits can fund interest costs if borrowing rates are no greater than 5%!
And borrowing rate is below that of 5% on loans and overdraft.
There are other costs in the financing section, such as finance lease, acquisition costs, debt costs, PLC costs, etc. Including these costs would push annual financing costs pass 8%.
I fear that Premier Oil will need to raise more debt in the future, if oil prices don’t rise fast and consistently enough.
Barrels of debt
Another way to represent the seriousness of Premier Oil’s debt is to convert it into “barrels.” Below you see how much debt consume each barrel of oil annually and life of production (using P2 reserve data).
The irony is as oil prices fell, the opposite happened. Debt per barrel rose to $120 and just like the oil price it has now stabilise around that region.
A more important assessment of Premier’s oil reserves and that debt per barrel reserve rose from less than $1 to $10 per barrel.
To understand this debt per barrel of oil reserve better, it’s a bit like paying royalties to the host country, in exchange for extracting their oil. Instead of paying royalties the oil producer need to pay their lenders. For Premier Oil, their total borrowings have increase the cost of extracting oil on that basis.
Premier Oil valuation is close to all-time highs
You may be scratching your head about Premier Oil being at all-time highs because the share price has fallen by 85%, if you focus solely on the equity.
Add debt into that equation, and it is a different outcome on paper and visually.
A slightly more detail chart is to include Premier Oil’s share price trough at 19 pence before recovering to 52 pence.
That took their market valuation to below £100m, a fall of 95%. Meanwhile, you see Premier Oil’s enterprise value or (EV) fall by 40%, due to the increase in total borrowings. When the share price recovered, it added £180m in market equity, but it also saw net debt increasing by £750m. That forced Premier Oil’s enterprise value to recover near all-time highs. And since then, Premier Oil’s share price has stopped appreciating!
I wonder why 🙄
Also, the change in Premier Oil’s enterprise value tracks their bond prices closely.
Premier Oil Finance Ltd (6.5%) 2021 Bonds
Refer back to the 2016 lows, when it was trading around 38 pence to the £1 (par value). Back then it was yielding 16.7%. Now, Premier’s bonds are back to 88 pence. Although its share price has recovered by 150% it doesn’t have yield protection and market equity gets wiped out first!
I hope this post explains the importance of debt and the ways it affects companies’ valuation.
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The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.
Finally, the writer does not own the company’s stock, unless stated otherwise.