I say that but that isn't exactly what I mean. You can happily mix debt and oil production, the cost of debt can be set off against corporation tax and as long as you don't have too much it can improve your equity returns a treat, it even makes sense to draw down debt as you develop an oilfield. When I say that debt and oil are a toxic brew what I mean is that debt doesn't mix with exploration and appraisal. It's not that they don't mix well, they shouldn't mix at all.
The oil business is pretty simple really, you produce oil, you sell it, you make money. Even at $50/bbl a North Sea oil producer should make a cash profit. That's because most of their costs were in the past, in the finding, or the buying of the oilfield, and in the development project. Production costs in the North Sea are on average $28/boe. Only the Dunlin field has been shut in as a direct result of the oil prices collapse.
The fact is, when times are tough, every producer pumps even harder as the price goes lower, because every extra barrel adds to cash flow and when prices are low management get very, very focused on every incremental barrel. Companies fire staff, stop investment in new projects and they even cut the amount of maintenance they do, which paradoxically boosts production, in the short term, as kit is taken offline less frequently. The very last thing they do is shut in production. It will take years to see the impact of this price crash on UKCS production, every project in the North Sea has a two to three year lead time, and no one stops a project once they have started. People are shocked that production remains high, they shouldn't be, the consequences are years away.
Enough of that, let's get back to debt, if you have production you should have a positive cash flow and servicing your debt should be no problem. When the banks lent the money they would have insisted on the borrowers having a hedging programme in place so they would be sure of getting their money back. Many's the producer today who is glad that the banks were so curmudgeonly in the past.
Oil production companies and projects that are past the point of final investment decision have debt capacity and companies are probably wise to use it. Though caution never bit anyone in the backside. What does bite you in the backside is debt before you know you really have a development project, before you have the project financed, or worst of all debt before you have found a drop of oil. This should not be a surprise to anyone, there isn't a bank (that knows the oil business) that will lend you 100% of the cost of a development project. They always want to see some equity going into the project and that amount will depend on the risk they see, the reservoir risk, the project execution risk, the country risk and the oil price risk.
For the pleasure of granting you this money the bank will also want to secure a first charge on the asset, the Licence or the Production Sharing Contract or whatever, so come final investment decision, as well as finding the equity to match the bank's money, if you have borrowed against the asset, you are going to have to find even more equity to clear that debt.
So if you are exploring or appraising, and you borrow the money to do that, all you have done is put off the evil day when you need to raise equity to pay off that debt, and there are only two ways to raise equity, you either dilute your asset by selling some of it off to another oil company or you dilute your shareholders by issuing more stock. For me debt in an oil company that doesn't have production, or at least a project that is properly underway, is a clear sign that dilution is coming, the only question is: "How much and at what price?"
But there is worse to come, if the markets are closed or nobody wants to invest in your project then the debt holders can end up in control of your prize assets, at that stage dilution can become a wipeout.