Leslie Benedict: “Money isn’t everything, Jett”
Jett Rink: “Not when you’ve got it.”
Giant (1956)
And when you don’t got it, as independent oil guy Jett Rink knew, it is everything. The world may run on oil, but the oil industry runs on capital, and for some US shale producers that capital appears to be drying up. After flowing downhill throughout the second half of last year, the price of West Texas Intermediate (WTI) crude oil (as of the date this article is being written) is currently at about US$30. Natural gas has faced a similar decline. Might the worst be over? Not yet. Credit Suisse believes that between 1864 and 2008, the four oil bear markets lasted on average two decades and the shortest 11 years. Expect more pain ahead for many exploration and production (E&P) companies who focus on shale oil, deep water oil, or oil sands (collectively, “unconventional oil”) with additional ramifications in the oil field services sector and other related industry segments. If commodity prices settle at or near today’s prices, many E&P unconventional oil companies may face a liquidly crises while others will require either in-court or out-of-court restructurings. To date, 48 North American E&P companies have filed for bankruptcy. Six E&P companies have filed bankruptcy so far this year. Oil has had its weakest start in history and has negated five year gains.
The current downturn is a reminder that oil and gas exploration and production has always been a cyclical business. Memories of the last downturn in the sector may have faded but investors should keep in mind some of the unique industry and legal issues involved in oil and gas finance.
Weak global demand and the quest for yield
The immediate cause of the present oil price collapse is found in increasing production and weak demand for all commodities and loans since 2008 despite the herculean efforts of central banks to restart global demand via ultra loose monetary policy. Since the Financial Crisis of 2008, the US Federal Reserve and central banks across the world have increased debt, artificially kept interest rates low and devalued their currencies.
Oil prices rose with a weak US dollar and interest rates near zero in 2009. As prices passed US$80 per barrel in late 2009, unconventional oil production began in earnest. Low-interest rates forced investors to look for yields better than they could find in the US Treasury bonds or conventional savings instruments. Money flowed to E&P companies through high-yield corporate bonds, loans, joint ventures and share offerings.
The extended period of ultra-loose monetary policy, including both exceptionally low interest rates and huge expansions in the balance sheets of central banks helped produce the highest sustained oil prices in history. They also led to investments that are not particularly productive but promise higher yields that can be found otherwise in a zero-interest rate world.
A US-led supply surge from high-cost unconventional fields such as the Bakken, Eagle Ford and the Permian Basin outstripped demand last year and sent oil prices spiraling downwards. The rout deepened in November 2014 after OPEC, led by Saudi Arabia, its largest producer, refused to cut production. Other sizeable producers, like Russia, are hard pressed economically and need to keep producing for current cash income. And this is before the impact of Iranian oil coming back into the market.
The key to recovery is increased demand. With demand from China dramatically down and the potential for recession in many other sizeable energy consuming markets, the short-term scenario for demand does not look promising.
Continuing technical innovation which increases production from existing fields and new areas can also be a factor going forward, as it has been over the past decade or so. This can further increase supply from one or more regions of the world, often in dramatic fashion and/or at lower cost than some current production techniques.
E&P restructuring drivers
Since the 1970s, oil companies have put up their own reserves as collateral for loans as a way to secure improved lending conditions. E&P companies rely on reserve-based lending (RBL) to fund operations. In return, banks demand to revalue those reserves every six months, in April and October —a process called “redetermination”. Under RBL facilities, banks agree to lend up to limits set by the value of the borrower’s proved oil and gas reserves. They then adjust those limits periodically to maintain adequate loan-to-value and cash flow coverage ratios.
During the previous round of redeterminations last autumn, banks cut limits for most customers between 10 and 20 per cent. With oil still languishing at about US$30 a barrel, analysts say that the next round could be just as severe. As reported recently in the Financial Times, John Shrewsberry, chief financial officer of Wells Fargo, one of the most active lenders in US energy, told an industry conference in Miami that borrowing availability would be about “10 or 20 per cent down” again in the spring. Banks have also been warned by the Office of the Comptroller of the Currency, the federal regulator, to watch out for the risk involved in lending to oil and gas companies, prompting fears that loans could be withdrawn from businesses that would be financially viable if they were given a little more time.
In times of steep declines in commodity prices, most E&P companies will find the availability for additional borrowings under an RBL facility reduced, in some instances to a level below the aggregate principal amount of loans outstanding, resulting in a borrowing base deficiency. Once a borrowing base deficiency has occurred, most RBL facilities will provide the borrower the option to add additional collateral with a value equal to at least the deficiency amount or to pay down the outstanding loans in an aggregate amount equal to the deficiency in a single payment or in equal installments of three to six monthly payments. In a typical RBL financing, substantially all of the collateral has already been pledged to the lenders as collateral, which leaves the borrower only the option of paying down the debt. Choosing to repay the deficiency amount in installments gives the borrower a short window of time to raise capital, including by selling properties or securing additional credit through junior lien or subordinated debt, in order to avoid an event of default under its RBL facility.
Financing alternatives
The cliché about the hydrocarbon business is that the cure for low prices is low prices, meaning that excess production should lead to a mass wave of insolvencies, cutbacks in activity and eventual price recovery for the rational, hardy survivors. But to date, that does not seem to be happening. Relatively strong debt and equity markets (aided by private equity and hedge funds) have allowed many energy companies to access the financing needed to fight another day.
At the corporate level, there are 2nd lien debt (bond or loans) “replacement” revolvers, DIP financings and equity investments. According to Bloomberg, oil companies have sold US$61.5 billion in stocks and bonds since January 2015 as oil prices have tumbled. Approximately half the money has been used to pay down or re-structure debt. According to Bloomberg, drillers in the Permian Basin, the biggest US shale field, have raised at least US$2 billion from share sales over the past eight weeks. And more issuances are on the way as producers try to avoid piling on additional debt. Pioneer Natural Resources Co.’s 12 million-share issuance on Jan. 5 was followed a week later by Diamondback Energy Inc.’s announcement of a four million-share sale. Private equity firm Kayne Anderson Capital Advisors LP is investing in a startup called Invictus Energy LLC with $150 million to drill the Permian and the Eagle Ford Shale.
At the asset level, there are many creative ways to invest in E&P companies, including, production payments, net profit interest, overriding royalty interest and out right purchase of a stake in the working interest. Whether acquired as part of a recent restructuring initiative or historical purchase, investors who own such carved out royalty interests need to take inventory of counterparty risk and how these positions will be treated in a bankruptcy, including the potential risks of contract recharacterization or rejection and clawbacks of payment already received. For instance, when these types of interests are structured correctly, the party advancing the money is treated as a purchaser of the future production. If the borrower fails, the oil and gas subject to the production payment belongs solely to the investor and cannot be borrowed against or sold by the debtor. Other creditors of the borrower have enormous incentive to attack the transaction and have it characterized as a financing rather than a sale of assets. If an attack is successful, an investor may find themselves a creditor potentially holding a large unsecured claim against a debtor as opposed to holding what they thought was a separate property. That claim will be subject to treatment in a plan of reorganization.
Oil and gas restructuring considerations
E&P companies facing excess leverage or insufficient cash flow may pursue restructuring strategies out-of-court and, if necessary, reorganization in court by filing for bankruptcy, most often under Chapter 11 of the United States Bankruptcy Code (Bankruptcy Code). The typical parties in an energy restructuring or reorganization include the company as debtor, management, secured lenders, bondholders, potential asset purchasers, trade vendors, service vendors, oil and gas lessors, contract counterparties under joint operating agreements, derivatives counterparties, co-working interest owners, farmors, farmees, production payment counterparties, first purchasers and equity holders. Additionally, the Bankruptcy Code provides standing under appropriate circumstances for statutory committees of creditors and equity holders, and potentially for appointment of a bankruptcy trustee or examiner.
E&P cases also present some unique legal issues compared to most Chapter 11 cases, including (i) whether the personal property or real property rules apply (which provide for different rights and time periods), (ii) how special state law rights and priorities such as liens and royalties are treated vis-à-vis secured and other creditors, (iii) whether certain production payments are true sales or disguised financings (as highlighted above) and (iv) whether environmental and clean up obligations can be discharged in the bankruptcy and how such claims are classified and treated.
It is important to note that bankruptcy is a tool and not a strategic plan by itself. Among the tools bankruptcy provides are: (i) a breathing space from creditor payment demands and remedies, (ii) the ability to borrow funds or use cash collateral (e.g. cash on hand and incoming receivables and payments) on a post-petition basis to fund its business, (iii) the ability to sell assets to fund operations often on a free and clear basis, (iv) the ability to pay certain claims at a large discount and/ or over time, (v) the ability to bind holdouts and dissenting creditors in certain situations, and (vi) the ability to reject certain burdensome contracts and leases. Companies that restructure crippling debt loads can often emerge from bankruptcy and start life anew, but with the latest fall in energy prices, even a freshly capitalized balance sheet may not be enough to save the company
Indeed, bankruptcy by itself does not solve problems such as ongoing revenue and pricing issues or the need for going forward capital and trade creditor support. For example, when Samson Resources filed for bankruptcy in September 2015, wiping out US$4.2 billion of equity, the expectation was that second lien lenders, in the middle of the capital structure, would take over the company, wiping out the junior debt but paying senior debt holders 100 cents on the dollar. Now that assumption is being questioned and the pre-filing agreement with creditors has fallen apart. With the drop in energy prices “elements of the restructuring agreement, including refinancing senior debt and a commitment to inject new money, are likely no longer feasible”, according to a court document filed on December 17, 2015, in Delaware. “Any new restructuring would likely provide significantly less value for stakeholders than the transaction (originally) contemplated.” Second lien lenders who expected to take over Samson had pledged to put US$400 million into the company. But with prices of natural gas less than US$1.75 per million British thermal units —when the investment thesis of the original owners required prices of US$4 per mmbtu —“it was rational to take another look”, said one person involved in the talks. In its attempt to survive, Samson has cut costs and suspended all drilling.
Conclusion
Although the immediate cause of the collapse is over-production of tight oil, the key to recovery is a material increase in demand. Worldwide demand for oil has increased—its just that the rate of increase in demand has dramatically slowed down. The problem is structural and firmly rooted in the speculative money that was funding under-performing US unconventional oil companies since 2010. A possible first step to price recovery is the severing of capital supply to E&P companies that could not fund their operations from cash flow when oil prices were more than US$80 per barrel. If this does not happen, the world could be in for a long period of low oil prices. Until then, distressed investors should remain mindful of the inherent benefits and risk of investing in the E&P space as they evaluate opportunities resulting from this downtown.
