Companies engaged in the discovery, exploration, and production of oil and gas are in dire straits. These so-called upstream firms are entirely reliant on a supportive commodity price and willing capital markets. Not surprisingly, the extreme collapse in oil and gas prices, and greater market uncertainty from related environmental regulations, have brought the industry to the brink. Due to escalating losses and massive amounts of debt, upstream firms are going bust, with more likely to follow next year.

Large upstream firms including Linn Energy (NASDAQ: LINE) and Vanguard Natural Resources (NASDAQ: VNR) have seen their stock prices lose 78 percent and 91 percent of their respective values over the past one year. Increasing domestic production was once thought to be a gold mine for the oil and gas exploration and production industry. But stunningly, booming U.S. production now appears to be the cause of the industry’s downfall.

Commodity prices have shown no signs of recovering in 2015, as inventory levels remain high, setting the stage for another painful year ahead for upstream firms.

How the Oil and Gas Industry Destroyed Itself

New technological advancements in oil and gas drilling have unlocked oceans of previously untapped oil and gas. One such technology is hydraulic fracturing, commonly referred to as fracking, which involves pumping water into the ground to break up the earth, thereby releasing natural gas to be captured. While fracking was initially thought to open the door to the next energy revolution, it has been very negative for the oil and gas industry for a simple reason: it caused commodity prices to crash as suppliers continued to pump above the threshold of demand.

Oil and gas production is at record levels in the United States. It was widely assumed that higher production would allow the U.S. to secure energy independence and become much less reliant on OPEC and foreign oil. What the industry did not realize, however, is the disastrous effect lower oil prices would have on the oil industry itself. West Texas Intermediate crude oil recently fell below $40 per barrel in the United States, an astonishing decline from its peak levels. Oil traded above $100 per barrel as recently as 2014. As a result, upstream firms have endured huge losses.

For example, Linn Energy lost $1.6 billion in the third quarter. In the third quarter 2014, the company incurred just a $4 million loss. Vanguard has suffered a similar fate as Linn. It lost $468 million last quarter, compared to a $109 million profit in the same quarter last year. Unfortunately for the industry, conditions are not expected to improve any time soon.

Balance Sheets are Stretched

Making matters even worse is that the oil and gas industry engaged in a wave of mergers and acquisitions activity just before oil prices collapsed. When commodity prices were high, firms paid handsomely to obtain acreage in some of the highest-profile production areas of the United States, including the Bakken shale in North Dakota and the Permian Basin in Texas. Companies assumed that the good times would last forever, and loaded up on debt to finance M&A. This has turned out to be a disastrous move.

For example, Linn Energy acquired Berry Petroleum, which has left the company saddled with more than $10 billion in long-term debt and just $344 million in cash.

Bloated balance sheets now threaten the very economic viability of many firms. Early next year, banks will re-evaluate the assets and reserves held on E&P balance sheets. It is likely that, in order to continue receiving financing, companies will need to dramatically reduce the value of their oil and gas assets, given the low commodity price environment. And, as if things weren’t bad enough, there is still the prospect of rising interest rates and the deterioration in the willingness of capital markets hanging over the oil and gas industry’s head. This will only strain balance sheets further across the industry.

The Unforeseen Environmental Impact of the Fracking Revolution

Another unintended consequence of the fracking revolution in the United States is the negative impact on the environment and the prospects of new regulations. Residents in many cities where fracking activity is most common are reporting adverse environmental effects. For example, Oklahoma, which is home to a large amount of oil and gas being tapped into using fracking, has seen an alarming increase in the number of earthquakes this year. In fact, there have been more than 5,000 earthquakes recorded in Oklahoma this year alone. And, the magnitude of the earthquakes is rising. In 2014, Oklahoma experienced 585 magnitude 3 or higher earthquakes. Last year, that number was just 109.

But there are other environmental concerns as well. Hydraulic fracturing requires massive amounts of water usage. Moreover, the practice involves injecting chemicals into the earth, which raise concerns over the safety of ground water. As a result, it is likely that fracking will suffer increased political risk in 2016 and beyond.

Don’t Expect Recovery in 2016

As profitability across the industry crumbles, investors are bearing the brunt. Not only have upstream firms like Linn Energy and Vanguard Natural Resources suffered massive share price losses, but due to the financial strain, their distributions are getting cut as well. Investors had prized upstream MLPs due to their extremely high distribution yields. But earlier this year, Linn Energy suspended its distribution entirely, and Vanguard cut its own distribution by nearly half this year.

The rush to buy assets and expand production when prices were high has had a catastrophic impact on the exploration and production firms. To a large extent, these were self-inflicted wounds. Going forward, the industry will continue to grapple with hedges rolling off, rising interest rates, low commodity prices, public and regulatory scrutiny, and asset re-evaluations. As a result, there are far more negative catalysts than positive ones for the upstream industry heading into 2016. 

Companies to Watch

Breitburn Energy Partners (NASDAQ: BBEP), which launched a massive acquisition of QR Energy for $3 billion in 2014 to become the biggest oil-weighed MLP in the United States. Breitburn shares are down 87 percent from their 52-week high.

Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.