By Brock Hudson
Most industry analysts agree that the global oil supply and demand equation is reaching parity and that commodity prices are past their inflection point. To support a recovery of the distressed oil and gas industry, investment dollars are pouring into the space in hopes of “buying low.” While the anticipation of increasing commodity prices is a poor basis for an investment thesis, it can provide significant tail wind, in conjunction with further asset development and a well-timed exit, in delivering attractive private-equity returns.
According to industry reports, there are more than 250 private-equity-backed teams with almost $100 billion in dry powder looking for investments in the upstream space. Meanwhile, mergers and acquisitions activity has fallen from almost $100 billion in 2014 to $35 billion in 2015 and $5 billion in the first quarter of 2016. This has led to considerable pent-up demand for buyers, and the acquisitions and divestitures market is expecting that the latest round of borrowing base redetermination season will deliver a steady supply of property sales that will put these assets in the hands of management teams that can better exploit the underlying resources. It is also hoped that there will be an increased supply of properties offered through sales of assets owned by companies in bankruptcy. Given the existing private equity commitments and the lack of current capital markets’ availability, it is expected that private equity-backed companies will be the dominant force in the A&D market as the recovery unfolds.
So far, more than 60 exploration and production companies have filed for bankruptcy, and many more bankruptcies are expected over the next 12 months. The majority of the companies that have filed bankruptcy in this downturn have followed a similar progression of prearranging the case with its creditors, filing with an immediate restructuring plan, flushing its debt by converting it to equity, and emerging from bankruptcy with the same management, the same assets and an improved balance sheet.
This process develops two significant problems. Primarily, the company emerges with limited liquidity, which hampers the availability to grow by exploiting and developing its asset base. Given the state of capital markets and bank debt availability for the industry, it is uncertain how growth capital will be funded. A second concern is the dysfunctional shareholder base that is created by the bankruptcy process. The new equity owners came to their position in a variety of ways and may have differing goals and incentives. For example, some of the new owners may have been par debt owners who desire income, while others could be hedge funds that bought the debt at a deep discount and must manage their hold times and exits to achieve the target returns that they are seeking. The disparity of ownership can lead to an unwieldy and undependable shareholder base and an unreliable source for follow-on capital needs.
Additionally, an emerging issue that may affect the [oil and gas] industry and private-equity returns for the foreseeable future is the role that bank leverage will play in the recovery. Banks continue to wrestle with recent Federal Reserve and Office of the Comptroller of the Currency (OCC) proclamations regarding capital requirements as they relate to future net revenue (FNR) and asset coverage tests. These struggles may limit the banks’ ability to play a significant role in the industry’s recovery. This will also have an impact on private-equity returns, as inexpensive bank debt may not be as readily available to help boost return on equity. The next several years will be a boom for alternative, non-regulated, energy lenders. These mezzanine debt players, who have a deep understanding of the industry and the underlying oil and gas assets, will play a significant role in launching the growth of many companies which will become the dominant industry players over the next decade. However, as industry conditions improve, the institutional memories of the debt capital markets will shorten, and one can assume that ample long-term debt will again be available to the industry.
As we look to the future, we anticipate that private equity- backed management teams will play a leading role in the A&D market and that direct investment private-equity funds will use a variety of investment structures to provide the liquidity necessary for the industry’s growth capital. The investment structures will be limited only by the industry’s collective creativity, and will range from non-recourse asset based facilities like mezzanine debt and DrillCo structures to corporate obligations like uni-tranche facilities, debt like preferred stock, and direct equity investments