They range from multi-billion-dollar corporations to mom-and-pop local operations, but unlike much of the rest of the world where domestic markets are dominated by state-owned giants, oil and gas production in North America is primarily in the hands of independent companies.
Even the simplest energy production is highly capital intensive, and unconventional shale production especially so. At $100 a barrel for crude, North American shale could support ambitious development and attract large revolving credit lines from major banks.
At a third that price, the pain has been broad and deep. Bank finance has dried up, debt is trading at steep discounts and bankruptcies, while still rare, are starting to increase.
“There are a lot of operating companies trying to raise capital for maturities, to maintain production, or just for liquidity,” says Dwight Scott, senior managing director, GSO Capital Partners.
“Credit is very tactical and we look at it that way. We see a world in which commodity prices are going to improve, but we don’t know when. It may take quite a while. Because of ratings downgrades and the price of the commodities we have seen bonds that were well above par down into the 30s, even though the companies were initially perceived as being well capitalised. That is creating opportunities, but also risks.”
GSO’s preferred method of seizing those opportunities is rescue capital. “If we can give an operator time, or liquidity for a few years, or an opportunity to delever, that is what we would rather do,” says Scott.
The alternative tactic is to buy the bonds of a company in trouble with the expectation that being a bondholder will translate into equity after a bankruptcy.
Just as GSO prefers rescue capital over loan-to-own, they also prefer be higher in the stack. “We would always rather go up the capital structure,” says Scott.
“We are willing, occasionally, to move down if we think that it is part of an overall plan to get the company to a better place. That is why we like the rescue approach. If we can be part of a convertible preferred or secured deal, then we can provide funds for a few years until the company can refinance or issue equity.”
Of all industries, oil and gas investing is the most literally bottom up. “The reserves in the ground are the crucial element of any transaction,” says Scott. “As a credit investor the most important part of the deal is the underlying asset base.”
GSO, which keeps engineers on staff, has a strong geographic sense and a bias toward certain basins with low operating costs and ample infrastructure, such as the Marcellus in Appalachia, the Utica in Ohio, and the Eagle Ford in south Texas.
“We focus on the companies that have assets in the basins we favour, then start to get in to the capital structure. If assets are less developed, then we want to be higher in the structure,” says Scott.
If reserves are more proved, developed and producing then GSO might consider other layers.
GSO invests in the energy sector through a variety of primarily credit-focused funds, backed by a loyal group of investors. “We have an exceptional group of LPs,” says Scott. “It is our job to communicate with them in times like this. They see a market where debt is off 50 percent and equity is off 80 percent. By and large they see it as an opportunity, but they, like we, are cautious and careful.”
As oil prices tumbled over the last 18 months, there was a good deal of debt investment in the sector. But KKR Credit, which manages around $34 billion, held off.
“We have no fixed allocation to any energy,” says Nat Zilkha, co-head of the firm’s credit unit. “Our investment in energy credit last year was de minimus. We have been waiting for enough capitulation that the opportunities to profit from a recovery would be available at much lower risk. These opportunities are starting to be evident.”
While boom and bust cycles are inherent in any commodity, Zilkha says that there were several factors exacerbating the most recent down cycle. “In the later stages of the run-up public debt largely displaced equity and private debt as a source of capital for oil and gas producers. That public debt was less demanding, plentiful and cheap, and a lot of operators were very aggressive in taking advantage of it,” he says.
As a result, the influence that private equity and debt managers had exerted in previous cycles was reduced this time. Then there was a vertiginous double dip.
In the face of surging global inventories the Organisation of Petroleum Exporting Countries (OPEC) announced in the autumn of 2014 that it would not reduce production. The price of oil tumbled to half of its recent peak of about $100 a barrel.
“From the OPEC meeting in November through the first quarter of 2015, the companies seeking capital were generally companies with weak assets and particularly bad capital structures. The ones with some runway and hedges in place held off on raising capital in hopes of a sustained rebound. Many of the deals that were done were ‘self-help trades’ of existing debt investors trying to move up the debt stack to protect their position,” Zilkha says.
Oil oscillated between $50-$60 a barrel for several months, but with production levels worldwide remaining high, crude slumped again to under $30.
“The second dip was quicker and harder,” says Zilkha. “Now everyone needs help, even the good companies with good assets and management teams.”
KKR Credit is flexible across geography and through the industry, including oilfield services, but has strict standards. “If we are not coming in at the top of the structure, we are not interested,” Zilkha states flatly.
While the double dip in prices was a strong indicator, it was not the green light itself. There has also been a significant shift in the availability of assets. “The big banks are beginning to sell their reserve-based lending facilities, which are the most senior claims in the debt stack,” says Zilkha. “That changes the nature of the game.”
There are two dynamics at play, says Jeff Nichols, partner at Haynes & Boone, a US law firm handling energy debt and bankruptcy: “There has always been the unique nature of oil and gas, and now you have private debt investors coming in because of the opportunities that are being created.”
Private debt has long had a place in the upstream energy sector, but the industry’s public pain is leading to heightened private investment interest. That is where the resource value comes into play. Oil and gas in the ground retain value even when an operator’s debt or the company itself is discounted or even eliminated.
“The US is the only country where you can own minerals,” Nichols says. “The conveyance of that real property means investors have a type of protection that does not exist with any other time of security interest or lien. To foreclose on a lien you need to go to court. But owning an asset is relatively protected. And the first thing courts or conservators do is to pay continuing operations to keep wells flowing. Sometimes you still have to fight, but that real asset opens a lot of possible approaches, including debt with an equity kicker.”
An important catalyst in the current debt play is that the banks who are usually first lenders to independent producers are reducing risk in an unexpected way. “The last three borrowing-base surveys have shown significant percentage projections of how much banks expect to reduce their borrowing base,” says Nichols. “But they have not been cutting as expected.”
Instead they have frozen new lending. “New deals that are no-brainers are getting turned down by the banks, so there is the opportunity for private debt,” says Nichols. “That will accelerate when existing debt needs to be refinanced. Even if distressed companies do not go for restructuring and instead opt for new equity, new owners will need financing.”
In all the talk of finance, Nichols stresses that the security of real assets does come with a caveat: “You’ve got to do your engineering. You need to know the producing fields. You’ve got to peel back the noise and understand overhead and understand the company. Maybe they made a deal in boom times that looks bad now. Many investors start with the financing, but you really have to find a consulting petroleum engineer and understand the investment field by field.”
Some were surprised by the collapse in the price of oil, says Amol Joshi, vice-president and senior analyst at ratings agency Moody’s. From his seat, though, “this is a classic supply-side disruption, and there is no line of sight currently to rebalancing”.
Oversupply has reached one to two million barrels, says Joshi, adding that Chinese demand is a concern even as supply from the US and Middle East continues.
And for high-cost unconventional US producers, there may be no easy answer. “Price may need to collapse to below cash costs to restore balance, and that is what we are starting to see,” says Joshi. “As a result, there are many over-levered operators. People got used to higher prices, so few companies kept cash on their balance sheets. We saw some not even hedging.”
In a cyclical commodity, hedging has been an essential survival tactic for operators, particularly at the smaller end.
“Companies hedge their production to provide a level of protection against oil and gas price fluctuations, and in 2016 and 2017 we see a significant decline in hedging protections, which means more companies are exposed to the current depressed prices and market conditions,” says Paul O’Donnell, principal analyst at consultancy IHS Energy.
“For most companies in the sector, 2016 is going to be another very tough year, as plunging revenues lead to balance sheet deterioration, and financial pressures mount.”
According to an analysis of North American exploration and production companies written by O'Donnell, production hedging for the 51 companies studied will fall even more in 2017, when just 4 percent of total production will be hedged, including only 2 percent of oil and 7 percent of gas.
RECOURSE TO RESTRUCTURING
Struggling producers have limited options, Joshi notes.
Buyers are biding their time so asset sales are difficult and operators have already cut costs and reduced capital expenses, sometimes to zero. And hedging, the saving grace of recent years, is also of limited help. The forward price curve means there is little immediate gain and some long-term risk of being stuck with current prices when recovery does begin.
Debt restructuring is one of the few recourses left, Joshi says, including exchanging unsecured senior debt for secured lines.
“Investors seem to like that as they jockeying for position in the stack. Existing investors are thinking that way and new investors who are buying bonds at steep discounts believe that the downside at this point is slim,” says Joshi.
He also notes that the larger debt investors seem to favour distressed exchanges rather than bankruptcy, because they feel their chances of recovery are higher. “If investors believe the operating company can survive through the current cycle, they prefer to push through and recover at the end,” says Joshi.
And so the battle for assets begins as those factors have combined to produce a perfect storm for producers and an almost flawless opportunity for investors like Scott and Zilkha.
A BRIEF HISTORY OF THE SHALE BONANZA
Since the dawn of the hydrocarbon age, commercial production was based on finding pockets of oil and natural gas. The formations were well known, but inaccessible, typically in shales and other sedimentary rock.
Three essential technologies came together to enable “unconventional development”, the shale revolution. The oldest is hydraulic stimulation. In the early days, wells were shocked or fractured with nitroglycerine or dynamite. High-pressure water is safer and more reliable. Surfactants are added to lower viscosity, such as sand or tiny ceramic beads to hold open the fractures. Toxic chemicals and light hydrocarbons have been used in the past, but today – despite its notoriety – fracking fluid is essentially sandy dishwater.
The second essential technology is powerful computing to discern complex three-dimensional seismic surveys. The result is a highly accurate map of the shape, depth, complexity and composition of the pay zone. The third component is directional drilling. After drilling to the depth of the target horizons, the drill bit is literally steered sideways to drill laterally. It is not uncommon today for a well to reach 8,000 feet deep and then turn and run another 8,000 feet sideways. Literally rocket science underground.
While all the components had antecedents going back decades, they all came together in the Barnett Shale west of Fort Worth, Texas, in the 1980s as developed by Mitchell Energy. By 2000, the technology was proven and the shale bonanza spread across the US and Canada.
All that computing, drilling and fracking comes at a price. The cost of a single well can range from $6 million to $12 million. And while most producers have slashed development, they have to keep producing. Oil flow is cashflow.