Higher oil prices won't save these producers
The price of oil rallied by more than 5% on Wednesday after it was announced that OPEC members had reached a loose agreement on an output cap set to be brought in later this year.
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This news from OPEC is a great boost for small-cap oil producers Enquest(LSE: ENQ) and Premier Oil(LSE: PMO), which have been struggling to keep the lights on as oil prices have remained depressed.
However, while higher oil prices will be a step in the right direction for these companies, managements will have to do a lot more to pull Premier and Enquest away from the precipice and place them on a stable footing.
Drowning in debt
Both Enquest and Premier have one glaring problem, debt. These two companies have built massive oil empires funded with debt, which made sense when the price of oil was trading around $100, but in today's world of $40 to $50 oil these mountains of debt appear to be unsustainable.
At the end of the first half of 2016, Enquest reported net debt of $1.68bn compared to a profit before tax and net of finance costs of $150m for the period. Management has estimated that the company's debt could hit just under $2bn by the end of 2017 as the group continues the development of its Kraken project in the North Sea. A deal to sell 20% of this oilfield could generate $170m for the firm bringing net debt down to $1.75bn the end of the year. With such a mountain of debt overhanging the company, it's no wonder that several weeks ago it was reported that the UK's Oil and Gas Authority is putting together a contingency plan for Enquest's assets if the company goes into administration.
Technically, Premier is in breach of its agreements with creditors. The company's debt-to-EBITDA ratio has exceeded the level lenders require the company to operate within, which means lenders could take control of Premier if they so wished.
Luckily, it looks as if banks are willing to give management some room for manoeuvre and have deferred the test of Premier's financial covenants while discussions around the company's existing debt arrangements continue. Nonetheless, even though lenders are granting Premier leniency now, there's no guarantee that this will continue.
Blessing and a curse
Low oil prices have been both a blessing and a curse to Premier and Enquest. Profits have fallen but so have costs helping these two groups to reduce overall expenditure and improve margins. Enquest's Kraken development, for example, is now expected to cost 13% less than when it was initially conceived.
The problem is that these cost savings won't last forever. If oil prices start to head higher again, so will costs. This leaves Premier and Enquest in a sticky situation. These companies need higher oil prices, but they can't afford higher costs, which will pile more pressure onto their strained balance sheets. Put simply, Premier and Enquest are stuck, and as their profits are at the mercy of oil prices, investors are unlikely to see any substantial return from these businesses.
Overall, even though the OPEC agreement is good news for producers, it might be best to avoid Premier and Enquest.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
