ALVAREZ & MARSAL READINGS IN QUANTITATIVE RISK MANAGEMENT

The Collapse of Crude Oil Prices: How Low and For How Long?

Part One: Impacts of Falling Prices

2 PART ONE: IMPACTS OF FALLING PRICES

THE COLLAPSE OF CRUDE OIL PRICES:HOW LOW AND FOR HOW LONG?

INTRODUCTIONThe dramatic movement in the price of crude oil was one of the major stories, and major surprises, of 2014 and 2015. Prices of crude oil fell by 50 percent in 2014 and the trend continued in 2015 (see Figure 1). For example, on December 31, 2015, the spot price of West Texas Intermediate (Cushing, OK) crude oil (WTI) was $37.13 per barrel, down nearly 66 percent from a peak of $107.95 on July 20, 2014. Thus far in 2016, the lowest daily spot price for WTI was $26.19, 75.7 percent below the July 2014 peak.

While most American consumers welcome the declines in gasoline prices that have accompanied falling crude oil prices, the impacts are not uniformly beneficial. In this two-part series, we examine the causes for collapsing oil prices, the impacts of persistently low prices on energy producers, and the consequences for U.S. banks that lend to energy exploration and production (E&P) companies, oil field service (OFS) companies, and the households and individuals that live in regions dominated by oil and gas exploration. Part One focuses on the impacts of falling prices on individual companies and on the real estate markets of energy-dependent areas. Part Two emphasizes the increased likelihood of default by these companies and individuals as well as the consequences for their lenders.

We conclude that variable oil prices are the natural consequence of changing supply and demand, as one would expect. Companies that extract, process and distribute crude oil, as well as companies that provide services to energy E&P companies, have operating

Bruce Stevenson | Managing Director | Alvarez & Marsal

2

profits that are closely correlated with oil prices. Share prices of these firms also vary closely with oil prices. As such, these companies will have a higher risk of default with falling oil prices and, if those prices fall far enough or stay low long enough, default and bankruptcy become certain.

Also, as expected, investors that take “long” positions in oil, in oil E&P companies and in oil field services companies can expect to see the value of those positions drop with falling oil prices. Banks and other lenders to the energy sector are effectively long oil prices and the value of their investments (e.g., loans) falls as oil prices fall. For these lenders, higher levels of defaults, rising loan loss reserves, and falling revenues and share prices are inevitable consequences.

The question for both energy companies and their lenders is not “how low can oil prices go” or “how long will they remain low” but both: “how low will they go and how long will they stay there?” The answer to this two-part question can only come from scenario analysis in which the oil companies and/or their lenders test the impacts of various scenarios of oil prices on individual E&P and OFS companies on the resultant expected defaults and loss and, for the lenders, the implications of these losses to their own capital. Fortunately, the steps to complete such stress tests are mathematically tractable and, thus, within the scope of most institutional investors, especially those that already conduct stress tests under the Dodd Frank Act Stress Tests. Mathematical testing of the impact of changing oil prices on real estate values, and the associated risk of mortgage defaults and foreclosures, in oil-sensitive regions is also feasible.

3THE COLLAPSE OF CRUDE OIL PRICES: HOW LOW AND FOR HOW LONG?

CAUSES OF FALLING OIL PRICESThere are a number of reasons for this dramatic collapse in oil prices. First, oil demand in Asia has dropped as the economies of this region have slowed. In the third quarter of 2014, China’s economy grew at the slowest rate in five years (7.3 percent) as a result of a slumping real estate market and weak domestic demand and industrial production. For the first time since 1999, the growth rate of oil consumption in the U.S. exceeded that of China in 2013. China also became a net exporter of oil in October 2014, as imports dropped 22 percent and exports surged 30 percent.

Second, production of oil in the U.S. grew exceptionally fast in the last five years. As shown in Figure 2, U.S oil production declined consistently from the mid-1980s until the late 2000s, but between 3Q2008 and its peak in 2Q2015, U.S. production of crude oil doubled.

U.S. crude oil production is a lagged response to oil price (Figure 2). As world oil supplies tightened in the late 1990s and early 2000s, prices rose dramatically commencing in 2003. Oil prices grew exponentially until 2008, at which point the WTI reached $145 in July 2008. The financial crisis and Great Recession temporarily reduced demand for crude oil such that the price fell to $25 per barrel in December 2008. Only in recent months has the dramatic decline in oil prices caused U.S. oil production to decline, albeit very slightly (Figure 2).

Figure 1: Historical Monthly Prices of West Texas Intermediate Crude Oil from 1986 to 2016 (source: U.S. Energy Information Administration)

PRICE OF CRUDE OILCushing OK West Texas Intermediate

1Q1986 to 1Q2016

$0

$20

$40

$60

$80

$100

$120

$140

1Q19

86

4Q19

86

3Q19

87

2Q19

88

1Q19

89

4Q19

89

3Q19

90

2Q19

91

1Q19

92

4Q19

92

3Q19

93

2Q19

94

1Q19

95

4Q19

95

3Q19

96

2Q19

97

1Q19

98

4Q19

98

3Q19

99

2Q20

00

1Q20

01

4Q20

01

3Q20

03

1Q20

04

4Q20

04

3Q20

05

2Q20

06

1Q20

07

4Q20

07

3Q20

08

2Q20

09

1Q20

10

4Q20

10

3Q20

11

2Q20

12

1Q20

13

4Q20

13

3Q20

14

2Q20

15

1Q20

16

PRIC

E PE

R BA

RREL

WTI Spot Price - 11 February 2016 - $26.19 / barrel

4 PART ONE: IMPACTS OF FALLING PRICES

Major improvements in hydraulic fracturing (“fracking”) and horizontal drilling in the first decade of the new millennium were the major factors for this growth. Until recently, sustained higher prices have enabled production growth from these techniques. Their growth has been higher than other sources of oil and their share of world oil supply rose to 3.7 percent at year-end 2014, up from 0.5 percent in 2008. As of 2015, the U.S. had the highest production of crude oil and related liquids of any country, including Saudi Arabia.1

The price-induced growth in oil production in the U.S. occurred just as global energy prices, and the advent of new extraction technologies, prompted increases in production elsewhere in the world. Since 2008, Russia’s daily oil production has grown by 11 percent and Canada, also using the new technologies, experienced a 33 percent increase in daily production.

A third reason why oil prices have fallen, as denominated in U.S. dollars, is that oil prices and the value of the U.S. dollar are inversely related. As the dollar began to weaken in early 2002, the price of oil increased exponentially and, once the dollar began to recover in both mid-2008 and early 2015, the price of oil fell (Figure 3).

The relationship of oil price to the value of the dollar is especially strong since 2000. Specifically, the correlation of the quarterly average of the WTI oil price to the quarterly average value of the U.S. dollar against major currencies was -0.881 between 1Q2000 to 4Q2015.

CONSEQUENCES OF FALLING ENERGY PRICESIf oil prices remain low in 2016, there will be significant consequences to E&P companies, oil field services firms, the communities in which oil dominates economic activity, and the lenders and investors in these companies and communities. We see primary and secondary impacts resulting either directly or indirectly from falling oil prices.

Primary direct effects are those that occur immediately or in the short term as direct consequences of falling energy prices. These effects include reduced profitability of oil and gas E&P companies and elevated default probabilities and default rates among these companies. Other primary direct effects are reduced capital expenditures by E&P companies as new exploration and drilling

Figure 2: Oil Production in the United States in Relation to West Texas Intermediate Oil Price from 1986 to 2015

PRICE AND U.S. PRODUCTION OF CRUDE OILU.S. Energy Information Administration

1Q1986 to 4Q20151Q

1986

4Q19

863Q

1987

2Q19

881Q

1989

4Q19

893Q

1990

2Q19

911Q

1992

4Q19

923Q

1993

2Q19

941Q

1995

4Q19

953Q

1996

2Q19

971Q

1998

4Q19

983Q

1999

2Q20

001Q

2001

4Q20

013Q

2003

1Q20

044Q

2004

3Q20

052Q

2006

1Q20

074Q

2007

3Q20

082Q

2009

1Q20

104Q

2010

3Q20

112Q

2012

1Q20

134Q

2013

3Q20

142Q

2015

1Q20

16

$0

$20

$40

$60

$80

$100

$120

$140

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

PRIC

E PE

R BA

RREL

THOU

SAND

OF

BARR

ELS

PER

DAY

U.S. Field Production (left axis)Price of Cushing OK WTI (right axis)

1 Source: U.S. Energy Information. Data include crude oil, lease condensate, natural gas plant liquids and refinery processing gain.

THE COLLAPSE OF CRUDE OIL PRICES: HOW LOW AND FOR HOW LONG?

exploration dominates economic activity, elevated defaults and losses on loans tied to real estate are likely as the values of assets (principally real estate) fall with contraction of that activity. Foreclosures on residential mortgages are one example. We address these secondary effects in more detail in the second paper.

We examine each of these effects in detail.

PRIMARY DIRECT EFFECTS. A direct effect of falling oil prices is reduced operating profits for oil and gas E&P companies. As an example, we focus on Occidental Petroleum. Occidental’s primary business is the extraction and production of crude oil and, as a global E&P firm, it has direct exposure to the variability in crude oil prices.

In Figure 4, the operating profits2 of Occidental Petroleum are strongly correlated with oil prices over the last 26 years (r-squared = 0.892). In fact, one can easily build a mathematical equation to predict Occidental Petroleum’s earnings before interest, taxes, depreciation and amortization (EBITDA) as a function of oil prices.3

5

is halted, even though production at existing wells is maintained. Restructurings of these companies, including layoffs of employees, are inevitable consequences.

Primary indirect effects are those that occur immediately or in the short term but are indirect consequences of falling prices. Among these effects are higher default probabilities and default rates among OFS companies and other firms servicing E&P regions as well as higher loan loss provisions and charge-offs at banks that have loans to such companies. Banks lending to these companies will experience reduced demand for loans, and in turn, reduced loan revenues as energy companies scale back investment and capital expenditures. Finally, counterparties long oil price swaps will see the value of those swaps fall with falling oil prices.

Secondary indirect effects include those that result from the impact of oil prices cascading through local economies affecting sectors not directly related to energy exploration, production or distributions. Within geographic areas in which oil and gas

Figure 3: Value of the U.S. Dollar in Relation to West Texas Intermediate Oil Price from 1986 to 2015

2 During 2014 and 2015, Occidental Petroleum reported a number of major restructuring activities including the sale of significant properties and operations in which the firm recognized the decline in value due to the reduced price of oil. For this analysis, the losses on these transactions are excluded from our estimate of profits from normal operations; our estimate then is earnings before taxes, depreciation, amortization and asset impairments.3 Quarterly EBITDA = (35.180 * Spot WTI Price) +1,484.40. This equation is a simplification of a complete forecasting model that would take into account the lag structure of oil price and it does not take into account any future restricting that might be undertaken by the firm.

CRUDE OIL PRICE AND THE VALUE OF THE U.S. DOLLAR1Q1986 to 4Q2015

PRIC

E PE

R BA

RREL

OF

WES

T TE

XAS

INTE

RMED

IATE

CRUD

E OI

L (C

USHI

NG, O

K)

TRAD

E W

EIGH

TED

U.S.

DOLL

AR IN

DEX:

MAJ

OR C

URRE

NCIE

S

1Q19

864Q

1986

3Q19

872Q

1988

1Q19

894Q

1989

3Q19

902Q

1991

1Q19

924Q

1992

3Q19

932Q

1994

1Q19

954Q

1995

3Q19

962Q

1997

1Q19

984Q

1998

3Q19

992Q

2000

1Q20

014Q

2001

3Q20

031Q

2004

4Q20

043Q

2005

2Q20

061Q

2007

4Q20

073Q

2008

2Q20

091Q

2010

4Q20

103Q

2011

2Q20

121Q

2013

4Q20

133Q

2014

2Q20

15

140

120

100

80

60

40

20

0

$140

$120

$100

$80

$60

$40

$20

$0

Value of U.S. DollarWTI (Cushing OK)

6 PART ONE: IMPACTS OF FALLING PRICES

The strong correlation between oil price and operating profits for E&P companies implies that the ability of these companies to service debt will be constrained as their operating profits fall in the current market. If such a company is highly leveraged with high debt burdens, the probability of default will increase as its debt service capacity declines with falling oil prices and falling profits.

The equity markets recognize the strong correlation between energy prices and operating profits of E&P companies and, as

a result, share prices of publicly-traded E&P companies are also strongly correlated with oil price. As shown in Figure 5, the correlation between the share price of Occidental Petroleum and WTI is very strong (r-squared = 0.864). Notably since the beginning of the collapse of oil prices, the equity markets value these shares at a premium to the WTI, perhaps because of the extensive activities undertaken by Occidental to eliminate or restructure underperforming businesses.

Figure 4: Operating Profits for Occidental Petroleum and the Price of West Texas Intermediate Crude Oil, 1999 to 2015

Figure 5: Relationship of Share Price for Occidental Petroleum and West Texas Intermediate Oil Price, 1986 - 2016

OCCIDENTAL PETROLEUMEarnings Before Interest, Taxes, Depreciation, Amortization and Asset Impairments

1Q1999 to 4Q2015

$5,000

$4,500

$4,000

$3,500

$3,000

$2,500

$2,000

$1,500

$1,000

$500

$0

$140

$120

$100

$80

$60

$40

$20

$0

OCCI

DENT

AL P

ETRO

LEUM

OPE

RATI

NG P

ROFI

TS ($

MIL

LION

S)

PRIC

E PE

R BA

RREL

OF

WES

T TE

XAS

INTE

RMED

IATE

CRUD

E OI

L (C

USHI

NG O

K)

Occidental Petroleum Operating Profits (left axis)WTI Crude Oil Price (right axis)

1Q19

99

3Q19

99

1Q20

00

3Q20

00

1Q20

01

2Q20

01

1Q20

02

3Q20

02

1Q20

03

3Q20

03

1Q20

04

3Q20

04

1Q20

05

3Q20

05

1Q20

06

2Q20

06

1Q20

07

3Q20

07

1Q20

08

3Q20

08

1Q20

09

3Q20

09

1Q20

10

3Q20

10

1Q20

11

3Q20

11

1Q20

12

3Q20

12

1Q20

13

3Q20

13

1Q20

14

3Q20

14

1Q20

15

3Q20

15OCCIDENTAL PETROLEUM

Relationship of Share Price to Crude Oil Price1986 - 2016

1Q19

864Q

1986

3Q19

872Q

1988

1Q19

894Q

1989

3Q19

902Q

1991

1Q19

924Q

1992

3Q19

932Q

1994

1Q19

954Q

1995

3Q19

962Q

1997

1Q19

984Q

1998

3Q19

992Q

2000

1Q20

014Q

2001

3Q20

022Q

2003

1Q20

044Q

2004

3Q20

052Q

2006

1Q20

074Q

2007

3Q20

082Q

2009

1Q20

104Q

2010

3Q20

112Q

2012

1Q20

134Q

2013

3Q20

142Q

2015

1Q20

16

$0

$20

$40

$60

$80

$100

$120

$140

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

WES

T TE

XAS

INTE

RMED

IATE

CRUD

E OI

L PR

ICE

($ P

ER B

ARRE

L)

OCCI

DENT

AL P

ETRO

LEUM

SHA

RE P

RICE

($ P

ER S

HARE

)

Occidental Petroleum Share PriceWTI Crude Oil Price

7THE COLLAPSE OF CRUDE OIL PRICES: HOW LOW AND FOR HOW LONG?

“

“

“

Why do we focus on the impact of oil prices on operating profits and on share prices? First, operating profits are the source of funds from which companies repay debt. If those profits fall too far, default is possible, and even likely. Second, a company’s falling equity price also means higher default risk because, with falling share prices, the company’s leverage increases in market value terms.

Occidental Petroleum is a good barometer of the impact of falling oil prices on investment-grade E&P companies and the fact that markets remain unsettled on their view of this sector. The major rating agencies still rate the company’s senior unsecured debt as investment-grade (A from S&P and A3 from Moody’s) while they have downgraded several other large U.S. E&P firms (e.g., Chevron, Devon Energy, Apache Corporation). Occidental’s debt trades at par or at slight premiums and yields to maturity are close to coupon rates. Equity investors are unconvinced with some analysts taking a very bearish view as the company’s share price continues to drift down.

The A&M default probability models take a somewhat bearish view. Our “logistic regression” estimates Occidental’s one-year default probability at 3.45 percent as of December 31, 2015, up from 1.66 percent on December 31, 2014. These probabilities are consistent with observed default rates of non-investment U.S. corporates. The higher default risk is a material issue for banks and other lenders to E&P companies and this is a theme that we explore in detail in Part Two.

For other publicly-traded E&P companies, similar relationships exist between oil prices and operating profits and between oil prices and share prices with the consequence of elevated default probabilities.

PRIMARY INDIRECT EFFECTS. As noted above, declining oil prices will have an impact on the companies that provide products and services to E&P firms, especially oil field services companies. We focus on Schlumberger Ltd, the world’s largest oil field services firm. It employs approximately 105,000 people representing more than 140 nationalities working in more than 85 countries and has four principal executive offices located in Paris, Houston, London and The Hague.

As we would expect, the EBITDA4 of Schlumberger is strongly correlated with crude oil prices (correlation coefficient = 0.903; quarterly results from 1Q1990 to 4Q2015) (see Figure 6). In fact, one can develop statistical forecasting models that predict EBITDA of Schlumberger as a function of crude oil prices just as we saw for Occidental Petroleum.5

IF OIL PRICES REMAIN LOW IN 2016, THERE WILL BE SIGNIFICANT CONSEQUENCES TO E&P COMPANIES, OIL FIELD SERVICES FIRMS, THE COMMUNITIES IN WHICH OIL DOMINATES ECONOMIC ACTIVITY, AND THE LENDERS AND INVESTORS IN THESE COMPANIES AND COMMUNITIES. WE SEE PRIMARY AND SECONDARY IMPACTS RESULTING EITHER DIRECTLY OR INDIRECTLY FROM FALLING OIL PRICES.

4 One-time accounting events that impact EBITDA are eliminated in this analysis.5 The simplified equation for Schlumberger is: Quarterly EBITDA = (27.544 * Spot WTI) – 91.045. Same caveats for the model of Occidental Petroleum EBITDA apply here.

8 PART ONE: IMPACTS OF FALLING PRICES

In addition to the strong adverse impact of falling oil prices on Schlumberger’s operating profits and share price, the firm is changing in other ways. In 2015, Schlumberger announced 21,000 layoffs accounting for 15 percent of its total workforce. Also in 2015, Schlumberger agreed to acquire struggling oil field equipment manufacturer Cameron International.

Other publicly-traded OFS companies show similar correlations between oil prices and operating profits and between oil prices and share prices.

SECONDARY INDIRECT EFFECTS. Bernard L. Weinstein, an associate director of the Maguire Energy Institute at Southern Methodist University’s Cox School of Business, noted that U.S. states with hydraulic fracturing and horizontal drilling had faster economic turnarounds after the recession in 2008 when compared to those who have no drilling activity. This economic growth has put real pressure on limited resources in some of these areas and it has led to dramatic increases in the level of deposits and lending within regions not used to such growth. With the collapse of oil prices, that economic growth is in jeopardy as companies

cut capital expenditures, lay off employees and sell assets. Rapid growth in the oil shale regions has created upward pressure on housing prices where demand has exceeded supply.

North Dakota is a very good barometer of these effects within a single state. The Bakken Formation is a series of sedimentary rock occupying about 200,000 square miles of the subsurface of the Williston Basin that underlies parts of Montana, North Dakota, Saskatchewan and Manitoba. It is named after Henry Bakken, a farmer in Tioga, North Dakota, who owned the land where the formation was initially discovered while drilling for oil.

The application of hydraulic fracturing and horizontal drilling technologies has caused a boom in oil production from the Bakken. Since 2000, the explosion of oil exploration and drilling in the Bakken shale formation following the financial crisis permitted a huge increase in the number of drilling rigs in the state (Figure 7). By the end of 2010, oil production rates had reached 458,000 barrels per day, thereby outstripping the pipeline capacity to ship oil out of the Bakken.

Figure 6: Relationship of the Price of West Texas Intermediate Crude Oil to the Operating Profits and Share Price of Schlumberger, LTD

SCHLUMBERGER LTDShare Price and Earnings Before Interest, Taxes, Depreciation, and Amortization

Compared to West Texas Intermediate Oil Prices1990 - 2015

$0

$20

$40

$60

$80

$100

$120

$140

-$500

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

WTI

CRUD

E OI

L PR

ICE

($ P

ER B

ARRE

L) /

SCHL

UMBE

RGER

SHA

RE P

RICE

($ P

ER S

HARE

)

SCHL

UMBE

RGER

QUA

RTER

LY E

BITD

A ($

MIL

LION

S)

Schlumberger EBITDA

WTI Crude Oil PriceSchlumberger Share Price

1Q19

90

4Q19

90

3Q19

91

2Q19

92

1Q19

93

4Q19

93

3Q19

94

2Q19

95

1Q19

96

4Q19

96

3Q19

97

2Q19

98

1Q19

99

4Q19

99

3Q20

00

2Q20

01

1Q20

02

4Q20

02

3Q20

03

2Q20

04

1Q20

05

4Q20

05

3Q20

06

2Q20

07

1Q20

08

4Q20

08

3Q20

09

2Q20

10

1Q20

11

4Q20

11

3Q20

12

2Q20

13

1Q20

14

4Q20

14

3Q20

15

9THE COLLAPSE OF CRUDE OIL PRICES: HOW LOW AND FOR HOW LONG?

The dramatic increase in active rigs caused a boom in the number of people working on these rigs, most of whom have traveled to North Dakota for jobs on the rigs or for other jobs supporting this exploration and production. So many people traveled to towns such as Williston, North Dakota that the new arrivers overwhelmed the towns’ hotels and other guest quarters. In the areas with the most active oil E&P, temporary living quarters consisting of rows of trailers and modular steel boxes, termed “man camps,” housed thousands of workers.

With the collapse of oil prices, layoffs have occurred in large numbers and many man camps are empty and have closed. Williston’s hotels, formerly booked solid for months, had 50 percent occupancy rates in March 2016. In Williston, as in many such towns, the spending on new roads, schools, hotels and developments during the booms now seems excessive and revenue is down nearly 25 percent from 2014. In North Dakota overall, there is a $1 billion shortfall in the state’s budget and the governor has ordered four percent cuts in the budget and has tapped almost $500 million from a rainy day fund formed in the boom years.

We believe that there are bubbles in housing prices in the shale oil regions and housing prices will continue to contract if oil prices remain low. In North Dakota, home prices track oil prices quite closely from 1986 to 2011 (Figure 8). However, beginning in mid-2012, home prices continue to accelerate while WTI oil prices stabilize at about $100 per barrel. The shortage of housing in areas with high levels of drilling and production activity undoubtedly put upward pressure on home prices.

For other states in which oil production is a significant component of economic activity, contraction in oil prices also means a loss of jobs and a loss of revenue. For example, the oil industry makes up about 30 percent of Wyoming’s revenue and a price drop of $5 per barrel means a $35 million loss in revenue to the state, impacting in roughly equal measure the state’s general funds for its schools. Although Texas is a more diversified economy, contraction in oil prices have brought layoffs to Houston, an important oil city, as well as significant pressure on the prices of both commercial and residential real estate. Similar impacts have occurred in other Texas cities as well.

Figure 7: Relationship of Active Oil & Gas Rigs in North Dakota

$0

$20

$40

$60

$80

$100

$120

$140

0

50

100

150

200

250

1Q2000

3Q2000

1Q2001

3Q2001

1Q2002

3Q2002

1Q2003

3Q2003

1Q2004

3Q2004

1Q2005

3Q2005

1Q2006

3Q2006

1Q2007

3Q2007

1Q2008

3Q2008

1Q2009

3Q2009

1Q2010

3Q2010

1Q2011

3Q2011

1Q2012

3Q2012

1Q2013

3Q2013

1Q2014

3Q2014

1Q2015

3Q2015

1Q2016

WES

T TE

XAS

INTE

RMED

IATE

CRUD

E OI

L PR

ICE

($ P

ER B

ARRE

L)

NUM

BER

OF A

CTIV

E OI

L &

GAS

RIGS

IN N

ORTH

DAK

OTA

NORTH DAKOTANumber of Active Oil & Gas Rigs

2000 - 2016

Active Rigs Statewide

WTI Crude Oil Price

10 PART ONE: IMPACTS OF FALLING PRICES

CONCLUSIONSBoom and bust is a consistent feature of the crude oil markets. The geometric increase in oil prices that led to the recent dramatic growth in oil production in the U.S. would almost certainly lead to a reduction in price when supply caught up with demand. However, a confluence of forces, including very significant increases in supply not only in the U.S. but in other parts of the world, coupled with a contraction in demand, has caused the price of crude to decline at a historically unprecedented rate.

The collapse in oil prices has direct impacts on oil E&P companies and OFS firms since their operating profits are directly correlated with oil prices. Declining profits mean these companies will experience higher probabilities of default as lower profits mean more difficulty meeting interest and principal payments on outstanding debt. For publicly-traded companies, equity investors recognize the stress created by declining oil prices and discount the value of their investments accordingly. Falling share prices also mean high risk of default as a company’s financial leverage increases in market value terms.

In Part Two, we investigate the impact of falling prices on the default risk of these companies and the impact of these defaults on the bond market and on banks that have lent to these firms.

Communities in which oil exploration, development and production dominates economic activity will also struggle as oil prices fall. Many towns in the U.S. shale oil regions have experienced both the boom of drilling associated with rising prices and the bust when oil prices collapse. For the regions in which development, such as building new real estate, occurred to match the peak of the boom, as in some towns in North Dakota, the contraction accompanying falling oil prices will be severe.

Figure 8: Relationship of Crude Oil Price to State-Level All Transactions Home Price in North Dakota

OIL PRICES AND HOME PRICESNorth Dakota

1Q1986 to 4Q20151Q

1986

4Q19

863Q

1987

2Q19

881Q

1989

4Q19

893Q

1990

2Q19

911Q

1992

4Q19

923Q

1993

2Q19

941Q

1995

4Q19

953Q

1996

2Q19

971Q

1998

4Q19

983Q

1999

2Q20

001Q

2001

4Q20

013Q

2002

2Q20

031Q

2004

4Q20

043Q

2005

2Q20

061Q

2007

4Q20

073Q

2008

2Q20

091Q

2010

4Q20

103Q

2011

2Q20

121Q

2013

4Q20

133Q

2014

2Q20

15

100

150

200

250

300

350

400

$0

$20

$40

$60

$80

$100

$120

$140

NORT

H DA

KOTA

STA

TE-L

EVEL

ALL

TRA

NSAC

TION

S HO

ME

PRIC

E IN

DEX

WES

T TE

XAS

INTE

RMED

IATE

CRUD

E OI

L PR

ICE

($ P

ER B

ARRE

L) Cushing OK WTI

North Dakota State HPI

11THE COLLAPSE OF CRUDE OIL PRICES: HOW LOW AND FOR HOW LONG?

PART ONE: IMPACTS OF FALLING PRICES

Companies, investors and government entities around the world turn to Alvarez & Marsal (A&M) when conventional approaches are not enough to activate change and achieve results.

Privately-held since 1983, A&M is a leading global professional services firm that delivers performance improvement, turnaround management and business advisory services to organizations seeking to transform operations, catapult growth and accelerate results through decisive action. Our senior professionals are experienced operators, world-class consultants and industry veterans who draw upon the firm’s restructuring heritage to help leaders turn change into a strategic business asset, manage risk and unlock value at every stage.

For more information, visit www.alvarezandmarsal.com.

© 2016 Alvarez & Marsal Holdings, LLC. All rights reserved.

Follow us on:

LEADERSHIP.

PROBLEM SOLVING.

VALUE CREATION.

Bruce Stevenson is a Managing Director with A&M in New York, with more than 27 years of experience in applying quantitative technology to challenges within the financial services industry. He has a unique blend of experience developing analytical solutions within banks and as a financial services consultant.

An industry thought-leader, Mr. Stevenson has published nearly 20 papers on risk management, portfolio management and quantitative analytics in lending and risk management journals.

Bruce G. StevensonManaging DirectorAlvarez & MarsalFinancial Industry Advisory Services, LLC600 Madison AvenueNew York, New York 100221-212-328-8595 (Office)1-917-565-2593 (Mobile)