Volatility in the prices of oil and natural gas continues to pressure and challenge many independent oil and natural gas exploration and production (E&P) companies, with more-highly-leveraged ones facing an ever-narrowing set of options as lenders cut back on credit. However, best-in-class E&P companies appear to be taking advantage of lower oil prices by issuing more equity, strengthening their balance sheets, and improving their flexibility.
A chilling effect in the high-yield market…
Both high-yield debt and private-placement debt appear on track to see significant declines in new issuance in 2016, a sign that lenders of all sorts are reluctant to further extend credit to leveraged companies and which in turn may be an admission that even the savviest credit-side investors are unsure of the current market’s outlook. At the current pace, high-yield-market issuances to E&P businesses—which stayed fairly steady in 2014 and 2015—will decline more than 70% in 2016.1 By the end of July 2016, eight companies had successfully placed new high-yield notes or bonds, demonstrating the seismic shift away from debt financing by leveraged E&P companies.
Figure 1: Bond and private placement 2014–16 annualized
Sources: Bloomberg data, S&P Capital IQ data
… and a drop in the availability of credit …
AlixPartners reviewed a basket of 57 E&P companies to determine how their borrowing bases changed from fall 2015 to spring 2016 under their reserve-based loans.2 Those loans, secured by the underlying value of the oil & gas controlled by a producer, undergo a redetermination twice a year with regard to the amount of funding available to be advanced against the reserves. To the extent there is an overadvance on the borrowings at the point of a redetermination, the company typically must repay that over-advance in the following quarters.
Redeterminations that have taken place so far in 2016 have been negative for the vast majority of E&P companies, leading to a wave of in-court and out-of-court restructurings.3
- More than 75% of the companies reviewed—43 producers—experienced redetermination declines, with borrowing bases dropping an average of 28%.4
- About 21% of the companies reviewed—12 producers—saw their borrowing bases remain unchanged.5
- Two businesses saw an increase in their borrowing bases because of acquisitions of high-quality assets.6
The current outlook for prices, as surveyed by recent reserve-based lenders, indicates a flattening of the price deck, with a 2017 mean of $42.52 West Texas Intermediate (WTI) / $2.56 Henry Hub (HH) compared with a 2020 mean of $51.14 WTI / $2.94 HH.7 Based on that, E&P companies will have to plan on raising capital for drilling programs and opportunistic asset purchases from sources other than their reserve-based lenders and the high-yield markets.
… are leading companies to tap equity markets
This year has seen sophisticated management teams at a number of independent E&P companies taking aggressive steps to generate liquidity during an unprecedented period of volatility in the commodity prices that underpin their equity prices. With the landscape seemingly barren of significant debt issuances for E&P companies for the foreseeable future, the industry is on track to issue $30 billion in equity capital during 2016—almost 500% more than in 2014—and more than it is projected to raise from bond issuances and private placements.
Although new equity issuances can dilute overall returns to investors, during a period of such uncertainty in the marketplace, a stock issuance can strengthen a company’s balance sheet by offering increased flexibility and reduced risk. Moreover, companies appear to be timing their issuances to the low points in the oil market, with the majority of equity offerings this year having come in February, when the WTI Index fell to the mid-20s.
Of the 34 companies with share offerings so far this year, the single biggest basin of focus is the Permian Basin in Texas rather than the traditional shale plays of the Bakken and Eagle Ford, which were the primary beneficiaries of high-yield issuances during 2011–14. Given that average breakeven costs can be substantially less in the Permian Basin versus the Bakken and, to a lesser extent, Eagle Ford, this makes sense: as activity picks up, it is likely to do so in a step effect, with companies using their capital to work the lowest cost to produce wells. However, it also suggests a potential opportunity for E&P companies focused on shale plays to utilize the equity markets in an effort to take advantage of today’s significantly lower operating costs relative to 2014’s. And there is opportunity to cut even further as commodity prices remain depressed; however, after cost reductions of 25 to 35% on average across the industry, additional cost cutting must be done strategically, as suppliers to E&P companies struggle with their own operational and financial headwinds. The significant and oftentimes indiscriminate cost-cutting exercises undertaken during 2015 now must be done strategically with an eye to ensuring key suppliers remain viable enterprises going forward.
Conclusion: Smart companies are taking advantage of capital market opportunities while aggressively managing liquidity and costs
Although share offerings can be dilutive to returns, we are seeing more and more best-in-class companies tapping the equity markets to improve their flexibility and reduce their risk—and it appears that investors are rewarding them. As the comparison in Figure 2 shows, E&P companies that have raised equity have outperformed the SPDR S&P Oil & Gas Exploration & Production Exchange-Traded Fund (XOP ETF) as well as the S&P 500 by a significant margin.
Figure 2: 2016 Shareholder value
Source: Bloomberg data
By using equity to build their war chests, these companies have enhanced their liquidity—and their ability to take advantage of today’s non-boom pricing cycle among labor and service providers—to explore more territory and ready more wells for production so they can maximize oil’s inevitable, if slow-coming, increase in market price. From the market’s perspective, the enhanced liquidity of those companies—and the strength that that liquidity gives them to take advantage of depressed asset prices and to fund drilling programs—have far outweighed the dilutive impact of share offerings.
Tapping the capital markets alone at opportunistic times is not the panacea for the E&P companies that are outperforming their peers. Those companies have aggressively managed liquidity, controlled general and administrative costs, and reevaluated their entire cost structures from the well bore to the first purchaser of the hydrocarbons. In addition, the best performers are planning for the future by developing strategies and laying acquisition plans that will take advantage of the inevitable rebound in commodity prices—when it finally arrives.
Compliments of AlixPartners – a member of the EACCNY