The energy sector is facing disruption and innovation. In this post we provide some insights on the challenges facing the exploration and production market. *
UPDATED: Mar 11, 2020
Part 1 – A Bad Decade for the Energy Sector
Since the 2014 oil price decline from over $100 per barrel, we have been witnessing the same movie over and over again. Many E&P companies have not been able to generate sufficient cash flows or raise enough equity to support their capital structures, and have gone bankrupt in the process.
And for many companies, even the recovery to a $60 oil price level was inadequate to produce compelling investment returns sufficient to attract funds to drill. And, given the recent plunge to sub-$40 levels, the situation has gone from dire to extreme for many producers.
From a dispassionate investor’s viewpoint, perhaps a reluctance to invest at this point is not all that surprising, given the lackluster performance of E&P stocks relative to the overall market over much of the last decade:
Energy Sector Share Performance
These disappointing results have not been limited to public stocks. Many energy-focused private equity firms have also experienced returns below expectations. The new sad word on the Street is “capitulation”.
If the investor community feels sufficiently burned from E&P investments to forswear the sector for the time being, life will continue to be brutal for independent companies – and their creditor constituencies (absent a huge oil price jump):
- Asset sales may not fetch acceptable price levels, and may even result in “no bids”.
- Without additional external capital to drill, E&P companies may never be able to build value greater than their outstanding indebtedness.
- Even bankruptcies that wipe out Old Equity and “equitize” the debt may result in zombie companies that still generate inadequate returns and fail to attract additional capital.
- The oil and gas business deals with managing a depleting asset. Without continuing investor support, this will be a US industry in long-term liquidation.
Can investor sentiment turn around? In an industry as volatile as oil and gas, of course it can. But can we count on continuing bullish sentiment in an increasingly green world?
Leveraged E&P companies are the canaries in the coal mine for what the future may hold. These birds aren’t looking too healthy at the moment.
RELATED: Are You The Canary in a Coal Mine?
But even when creditors are now underwater, all is not lost for boards interested in creating (and, in fortunate cases, maintaining) shareholder value. Key to such success is engaging investment banking help that is unconflicted and creative. Investment banks such as Gordian Group avoid creditor-side engagements in order to provide Board and shareholder-oriented advice that can translate into Old Equity recoveries.
The current dire market headwinds, together with our continuing desire to give advice untainted by creditor-side engagements, is what drove the formation of Seaport Gordian Energy. Combining Seaport Global’s deep energy expertise with our restructuring and distressed M&A skills makes our value proposition compelling for Boards, management and sponsors seeking to advantage existing shareholders.
Part 2 – The Valuation Environment for Energy Sector
A big key to the current predicament of investors in and lenders to independent E&P companies is the value of their underlying assets. In the old days (i.e., a few years ago), a property might fetch as much as the present value of cash flows for all proved reserves – Proved Developed Producing (PDP), Proved Developed Non-Producing (PDNP) and Proved Undeveloped (PUD).
The cash flows might have been discounted to the present at a rate as low as 10%, and the buyer may have accepted increasing oil price assumptions.
Today, that calculation is ancient history. Buyers discount cash flows (at current oil prices) for PDPs at rates at least as high as 15%. Any value attributable to PDNPs is suspect. And PUDs may get no value whatsoever. In other words, the new methodology has slashed values that sellers may expect to receive. And of course there are issues on what price deck to even begin with. Obviously, capital providers to the industry understand this.
We see buyers making other downside adjustments as well. Corporate G&A expenses are generally not included in the reserve cash flows and associated present value calculations. But if those expenses are large in relation to the asset base, buyers may take additional valuation haircuts.
Further haircuts may be in the offing if the prospect of green regulations becomes more imminent.
What are the implications? Well, each situation may be unique, so I don’t want to overgeneralize. But it is easy to see how there can be a world of “haves” and “have-nots” based on the economics of their drilling opportunities.
For companies without such attractive drill sites, the “drilling light” mandate can also create demand for low cost management teams focused on production rather than exploration. Drilling-oriented service companies would face declines in demand. Ugly.
Wouldn’t lower drilling activity result in lower volumes and higher prices? Maybe. Oil is a global market, and lots of geopolitical events can have impacts that could swamp the effects of lower US drilling rates.
But even if oil prices go up by a few bucks, the impact on drilling economics may not be sufficient to significantly alter the outlook.
As an independent E&P company, how do you know you are staring down the barrel of a problem? If the stock price is really depressed, if the debt is trading at a discount, and/or if the PDP PV15 is less than the face amount of debt, the company may be facing a crisis. We’re here to help.
Part 3 – Banks and the Energy Sector
US banks have lost many billions in E&P lending write-offs this past decade. Recent disastrous shale plays such as some within the STACK have added to the losses.
As a result, it should be no surprise that institutional lenders have been pulling back from energy lending through curtailments of borrowing bases and even leaving the sector entirely.
Although I am sure that the banks will be back in force when the E&P industry is in its next ebullient phase, that is cold comfort for today’s borrowers.
For an industry that has thrived on relatively cheap debt capital, the banks’ retreat is a problem that could have the effect of increasing the required rate of return hurdle for incremental drilling.
If your bank wants to continue to support your company with attractive financing, you would be well-advised to take all steps to preserve that relationship. But if you are faced with an increasingly-reluctant banking partner, you should consider a variety of steps to head off an existential crisis:
- Move assets out of the banks’ reach: Many credit agreements allow companies to enter into farmout arrangements (funded by friendly investors) with their PUDs. Assuming economically successful drilling, the company will have expanded its asset base (vs. its overhead levels), and would have created a parallel company to pursue opportunities.
- Stretch the banks’ maturities: In general, longer maturities work to the advantage of challenged E&P companies. With a longer time horizon, good things can happen, including an increase in oil prices. If asset values exceeded the face amount of bank debt, and if cash flows were sufficient to meet interest payments, there are chapter 11 alternatives that result in a court-imposed maturity extension without an adverse effect on Old Equity.
- Raise junior debt: If the company is still in the “healthy” zone, it can raise second lien or unsecured indebtedness. Even at an interest cost well in excess of bank debt, the junior debt still would have a cost materially below the PV15 threshold level. Not only can such financing lower the company’s weighted average cost of capital, but the prospect of incremental junior capital can be used to negotiate improved terms on the bank debt.
- Seek similarly-situated merger partners: As long as both companies have “as is” positive equity values, a successful combination could entail a dramatic overhead reduction that would inure to the benefit of Old Equity in each enterprise. Although banks may seek to exit pursuant to a change of control put, such efforts could be thwarted through chapter 11 techniques that would not affect Old Equity.
We at Gordian Group would be delighted to field questions on these and other issues E&P companies may have.
Part 4 – Weathering the Storm
Independent E&P companies are challenged by uncertain prices, depressed valuations, costs of capital that may exceed returns from drilling, bank nervousness and reluctance of many equity investors to participate in this environment.
To survive (and perhaps thrive), companies must make sure they have a stable capital structure and sufficient cash flows to be able to support the capital structure for the foreseeable future. To attract additional capital for drilling, they will have to do this and then some.
For many companies that wait to address the problems until the financial and default problems are acute, will be too late. The assets may be liquidated through a bankruptcy auction, and even the banks may not get out whole.
But it doesn’t need to end in such a bad place. If a company takes timely steps, it can set the stage for the long-term. And if the company is profitable and viable now, then it may be a real cash machine if the market conditions change for the better down the road.
We at Gordian Group welcome the opportunity to have discussions with E&P companies about how to implement such strategies.
* Gordian Group has recently announced a Joint Venture with Seaport Global, Seaport Gordian Energy, LLC, in order to assist companies and private equity firms create and preserve value in the energy sector.