A Q&A with Carl Marks Advisors
The oil and gas sector has been suffering a downturn characterized by a glut in the industry, lower prices, and over leverage. Doug Booth, partner, and Brock Hudson, managing director at the corporate restructuring and investment banking firm Carl Marks Advisors decode some of the trends impacting financing in this sector in the following Q&A.
Q: A dramatic industry shift is impacting mid-market businesses across all segments of the oil and gas sector. Could you explain how this shift is different from previous industry downturns?
A: The primary difference in this downturn is the amount of debt carried in the industry. Traditional bank borrowing bases have always been relatively safe loans. While the underwriting of senior debt has not changed much in the last 20 years, the capital structure of most borrowers with capital markets access has morphed considerably. From 2010 to 2015, $160 billion of second lien/sub-debt was issued by the industry and purchased by yield-seeking investors. This debt was rationalized by the blanket nature of shale reserves (with little risk of drilling a dry hole) and the high cost and capital needs for their development.
There are, of course, other factors that one could use to compare this downturn to those of the ’86, ’98, ’02 and ’09 that hinge on supply and demand, the strength of the U.S. dollar, inventories, OPEC capacity, the availability of hedging and shale supply, but that would quickly become a whole different conversation.
Q: In this market, what is the significance of redeterminations, and how do outcomes of 2016 redetermination compare to 2015? Any signs that the industry is improving? Despite modest price improvements, will redeterminations be used to reduce lender exposure to the industry?
A: A borrowing base redetermination is a petroleum-engineered mechanism that banks use to calibrate the amount their oil company clients can borrow based on the company’s oil and gas reserves in the ground. Redeterminations generally occur semi-annually and are affected by a company’s production profile, projected oil prices, lifting costs, plans for capital expenditure and the company’s hedge book. During 2015 and through the first half of 2016, most companies significantly curtailed their capital expenditures to manage liquidity and did not drill wells sufficient to replace the reserves produced. This, combined with the natural decline of production volumes, lower commodity prices and the time decay of high priced commodity price hedges, led to lower bank valuations. Most producers saw a 15 percent to 30 percent decline in their borrowing base levels during the spring 2016 redeterminations.
Despite the recent improvement in oil prices to around $50 a barrel, the finding and development costs in most basins still do not provide an appropriate risk-adjusted rate of return. Barring a dramatic commodity price increase, we anticipate the natural production decline and further hedge decay will pretty much offset the price increase to date in the next borrowing base redetermination season. While higher prices will allow companies to cash flow at the field and corporate level, it does not leave much liquidity for debt reduction or growth (through drilling or acquisitions).
Most banks we have spoken with are trying to reduce their overall oil and gas exposure. The borrowing base mechanism naturally helps with this, but regulatory oversight and industry exposure limits may limit the banks’ ability and willingness to fund growth capital for certain borrowers as the recovery continues.
Q: Given the state of the industry, what are the primary issues and concerns for mid-market businesses, particularly the oil field service (OFS) businesses, and why?
A: The primary concern for most companies right now is survival. Liquidity and balance sheet management will be key to living through the cycle. OFS companies have been hit particularly hard because their exploration and production customers have quit spending money and competitors are bidding work at breakeven margins to keep crews and assets working. There is currently too much supply in the system and all of the OFS companies are trying to be the last man standing. Pricing sanity will not return to the OFS sector until activity picks up or more participants are flushed from the system. There are multitudes of companies whose current revenue is a fraction of what earnings before interest, taxes, depreciation and amortization was two years ago. In these companies, previously prudent levels of debt are now overbearing.
Hundreds of thousands of employees have left the industry and this lack of manpower will prove to be a critical factor when activity picks up.
Q: What approach should mid-market E&P companies take to balancing liquidity needs? What options do they have, and what are viable approaches?
A: As previously mentioned, liquidity is the lifeblood for surviving industry cycles. The key things to focus on are managing costs, both general and administrative expense, and operating expenses, as well as maintaining an open line of communication with the bank. Bankers can handle bad news, but they do not like surprises. The key is to live within your cash flow and to focus on operations that optimize cash flow. During downturns, producers become considerably more efficient, and there are new technologies and processes that emerge as best practices and are carried into the next cycle. Unfortunately for the OFS sector, this often means that much of the equipment inventory becomes obsolete.
Q: What lending is available to mid-market oil and gas businesses? Who in the oil and gas sector is most vulnerable to borrowing base reductions and why?
A: The most vulnerable participants in the E&P space will be those that have maxed out their credit lines and have no other access to capital. We are concerned that banks may become an unreliable source of debt capital and will have little ability to be as accommodative as they have been in previous cycles. We are beginning to see the emergence of many non-regulated lenders eager to enter the E&P space, however the cost of the money will be considerably more than what E&P borrowers are used to paying. Through uni-tranche structures, preferred equity structures that look like debt, or mezzanine type structures, these alternative lenders may be able to help take out a battle-weary banker and provide some liquidity to fund growth capital expenditure.
Q: What new regulation has emerged to control risk in the oil and gas industry resulting from this dramatic industry downturn? Is it helping?
A: We think most of the industry would agree that regulation has done more harm than good. Portions of the Dodd-Frank Act have made it considerably more difficult and expensive to lend/borrow/hedge and banking regulations have hampered the lenders’ ability to work with borrowers through this cycle. Meanwhile, anti-carbon initiatives are not conductive to industry growth. There seems to be significant, unintended consequences associated with much of the emerging regulation.
Q: What new regulation has emerged to control risk in the oil and gas industry resulting from this dramatic industry downturn? Is it helping?
A: We think most of the industry would agree that regulation has done more harm than good. Portions of the Dodd-Frank Act have made it considerably more difficult and expensive to lend/borrow/hedge and banking regulations have hampered the lenders’ ability to work with borrowers through this cycle. Meanwhile, anti-carbon initiatives are not conductive to industry growth. There seems to be significant, unintended consequences associated with much of the emerging regulation.
Q: What is your outlook on the oil and gas sector and timing?
A: It seems that the production response to reduced pricing is starting to materialize and the supply-demand equation is reaching parity. We worry about demand in China and economic growth in the European Union. On the supply side, there are still some price caps with respect to worldwide crude oil inventories and drilled but uncompleted wells, or DUCs, in the United States, which amounts to just-in-time inventory from shale wells. We think companies need to organize themselves and maintain a capital structure to be competitive in a $40 to $60 per barrel price environment for the next several years.
Oil and gas is a fascinating industry with a lot of smart, industrious and resourceful people; however it has a voracious appetite for capital. While painful on a personal level, downturns help the business evolve and a more efficient and competitive industry emerges.
