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An earlier article examined the effect that lower oil prices may have on earnings for some E&P companies. The general conclusion was that moderately lower oil prices are unlikely make a big dent on profits and any significant stock price softness should represent a buying opportunity.

While this conclusion is generally valid, investors should remain wary of a potential danger: A softer oil price would weaken the balance sheets of highly leveraged companies and any debt service concern is likely to exert downward pressure on underlying stock prices.

As before, the same six well-known value plays are examined from a balance sheet borrowings perspective, the six being Bonanza Creek, Carrizo, Kodiak, Northern, Oasis and Whiting. The underlying assumptions used are: (1) An oil price decline of $10 would represent about 10% of the company's oil revenues as currently estimated by analysts, (2) no change to natural gas pricing, (3) no significant changes to P&L costs except for income tax, and (4) for simplicity purposes, and because the market tends to view most hedging activity as a short-term fix to an underlying longer-term fundamental problem, all hedges are ignored.

Bonanza (NYSE:BCEI)

Using existing analysts' EPS estimates of $1.64 for 2012 and $2.68 for 2013, Bonanza would generate cash from operations of $160 million in 2012 and $250 million in 2013. The company has a capex plan for 2012 of $250 million. Assuming the capex plan for 2013 will again be $250 million, this would lead to net debt by year-end 2013 of $94 million or just 13% of projected shareholders funds of $698 million.

Adjusting this for a $10 lower oil price, with EPS estimates of $1.33 in 2012 and $2.18 in 2013, Bonanza would have cash from operations of $140 million in 2012 and $220 million in 2013. With unchanged capex this leads to year-end 2013 net debt of $124 million, being a still low 18% of shareholders funds of $678 million.

Alternative measure: Year-end 2013 debt as a % of estimated total assets would increase from 9% to 13% if oil prices fell by $10 on average.

Overall verdict: Bonanza's debt levels will remain comfortable with plenty room to spare.

Carrizo (NASDAQ:CRZO)

Analysts are forecasting EPS for Carrizo of $2.46 in 2012 and $4.57 in 2013, producing cash from operations of $305 million in 2012 and $470 million in 2013. The 2012 capex plan is $440 million and the company expects to raise a similar amount of cash in 2012 by selling non-core nat gas assets together with the 5% stake in a North Sea oilfield. Additionally, during 2012, CRZO may spend about $200 million (rough estimate) acquiring additional land, particularly in Utica. Assuming 2013 capex is again maintained at $440 million, this would lead to year-end 2013 net debt of $566 million representing 72% of shareholders funds of $790 million. This net debt of $566 million would in fact be gross debt of $600 million senior notes, plus $34 million net cash with the $600 million equating to 76% of shareholders funds.

Adjusting for a $10 lower oil price, the 2012 and 2013 EPS would be $1.97 and $3.76. Cash from operations then comes in at $270 million in 2012 and $420 million in 2013. This would give rise to year-end 2013 net debt of $616 million, being 81% of $756 million shareholders funds.

Alternative measure: With oil $10 cheaper, year-end 2013 debt as a % of estimated total assets would increase from 27% to 30%.

Overall verdict: At year-end 2011 CRZO was very highly leveraged with debt at about 145% of shareholders funds. Strong profits growth is set to bring debt ratios to comfortable level during 2012 - and especially in 2013 with debt/shareholders funds falling to about 80% even with lower oil prices.

Kodiak (NYSE:KOG)

Analysts are forecasting EPS for Kodiak of $0.61 in 2012 and $1.07 in 2013 and this equates to cash from operations of $355 million in 2012 and $635 million in 2013. The 2012 capex plan is $585 million and assuming 2013 capex is maintained at about $600 million, this would lead to year-end 2013 net debt of $865 million representing 67% of shareholders funds of $1,285 million.

Adjusting for cheaper oil, the 2012 and 2013 EPS would be $0.46 and $0.84. Cash from operations then comes in at $300 million in 2012 and $545 million in 2013. This would leave year-end 2013 net debt at $955 million, being 78% of $1,220 million shareholders funds.

Alternative measure: With oil $10 cheaper, the year-end 2013 debt as a % of estimated total assets would increase from 33% to 39%.

Overall verdict: Debt levels at KOG have been climbing, but will not become problematic. Including the May 2012 offering, KOG now has $800 million of covenant-light senior notes and is thus largely free from reliance on restrictive bank borrowings. KOG's borrowing ratios are peaking in 2012 and should show improvement next year, even with lower oil prices. By year end 2012, debt/shareholders funds may hit 90% based on current estimates, or 99% with lower oil prices. In 2013, this ratio should drop to 67% using current estimates or to 78% with cheaper oil.

Northern (NYSEMKT:NOG)

Analysts are forecasting EPS for Northern of $1.23 in 2012 and $1.81in 2013 and this equates to cash from operations of $205 million in 2012 and $295 million in 2013. The 2012 capex plan is $405 million and assuming 2013 capex is again about $400 million, this would lead to year-end 2013 net debt of $378 million, representing 55% of shareholders funds of $684 million.

Adjusting for cheaper oil, the 2012 and 2013 EPS would be $0.88 and $1.36. Cash from operations then comes in at $170 million in 2012 and $250 million in 2013. This would leave year-end 2013 net debt at $423 million, being 64% of $656 million shareholders funds.

Alternative measure: Year-end 2013 debt as a % of estimated total assets would increase from 34% to 40% with a $10 drop in oil prices.

Overall verdict: In May 2012, NOG closed a debt offering whereby it raised $250 million via covenant-light senior notes. This is good and largely frees the company from restrictive bank borrowings in 2012. In 2013, NOG can again roll out a large capex program to support ongoing growth, while maintaining borrowings at reasonable levels even with a softer oil price.

Oasis (NYSE:OAS)

Analysts are forecasting EPS for Oasis of $1.64 in 2012 and $2.63 in 2013 and this equates to cash from operations of $425 million in 2012 and $645 million in 2013. The 2012 capex plan is $900 million and assuming 2013 capex is kept at $900 million, this would lead to year-end 2013 net debt of $1,060 million representing 103% of shareholders funds of $1,032 million.

Adjusting for a $10 lower oil price, the 2012 and 2013 EPS would be $1.25 and $2.03. Cash from operations then comes in at $365 million in 2012 and $550 million in 2013. This would leave year-end 2013 net debt at $1,155 million, being 118% of $976 million shareholders funds.

Alternative measure: Year-end 2013 debt as a % of estimated total assets would increase from 70% to 82% with oil prices $10 lower than at present.

Overall verdict: OAS has a well leveraged balance sheet. In 2011, the company issued 2 tranches of long-dated notes, $400 million due 2019 and $400 million due 2021, hence the $800 million long-term borrowings at the end of 2011, while also having cash of $470 million. It is this cash, together with cash from operations arising in 2012, that supports the large 2012 capex program. It is good that OAS used covenant-light notes to fund its expansion rather than borrowing heavily from more restrictive banks. However, it will be interesting to see if OAS can maintain its capital expenditures in 2013 at 2012 levels ostensibly via increased borrowings in part, or whether it has to curtail its growth aspirations, or whether it might boost shareholders equity via a share offering.

Whiting (NYSE:WLL)

Analysts are forecasting EPS for Whiting of $4.47 in 2012 and $5.08 in 2013 and this equates to cash from operations of $1,525 million in 2012 and $1,680 million in 2013. The 2012 capex plan is $1,800 million and assuming 2013 capex is also at about $1,800 million, this would lead to year-end 2013 net debt of $1,760 million, representing 42% of shareholders funds of $4,125 million.

Adjusting for $10 cheaper oil, the 2012 and 2013 EPS would be $3.40 and $3.80. Cash from operations then comes in at $1,315 million in 2012 and $1,445 million in 2013. This would leave year-end 2013 net debt at $1,995 million, being 50% of $3,997 million shareholders funds.

Alternative measure: Year-end 2013 debt as a % of estimated total assets would increase from 59% to 74% with lower oil prices.

Overall verdict: Borrowings as high as 74% of total assets aren't alarming, but on the other hand they don't give WLL a great deal of flexibility. If a lower oil price becomes a reality, it would not be a surprise to see WLL adopt a less aggressive growth profile or explore alternatives in order to aid liquidity.

Summary

As a broad rule of thumb, E&P companies may carry borrowings of up to 100% of shareholders funds and 40% or 50% of total assets or higher if it is well understood that the assets in question are worth considerably more than book value.

In the case of BCEI, CRZO, KOG, and NOG, all have projected borrowings that come under these hurdle rates. Oddly enough it is the two larger companies on this list - OAS and WLL - that have the highest borrowing levels and have the highest stock valuations on a forward earnings basis. Clearly, there are many factors at play here: ability to deliver growth, concern about dilution, share price liquidity benefits from being a larger company, and so on.

The reality though is that when you examine the numbers of both the large and small companies on the list, it is the smaller companies that have the best financial security, even with the reduced oil prices. Accordingly, based on the numbers presented, any market overhang coming from debt servicing ability that depresses these stocks is likely to be misplaced and short term in tenure. Moreover, if these smaller cap stocks move substantially down in the face of oil prices moving $10 lower, this should provide investors with an excellent buying opportunity.

Source: How Lower Oil Prices May Increase The Borrowings Of Select E&P Companies