Business/economics

Financial Pressures To Drive Industry To Consolidate

Pressure is growing this year for exploration and production (E&P) companies to “face the reality of a prolonged period of low prices,” said Alan Cunningham, technical director for Gaffney, Cline & Associates.

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Pressure is growing this year for exploration and production (E&P) companies to “face the reality of a prolonged period of low prices,” said Alan Cunningham, technical director for Gaffney, Cline & Associates.

Working for a company whose core business is calculating the value on oil and gas reserves has given him a view of how the financial pressure on companies has increased over the past year as it has become increasingly obvious that oil prices are going to remain low.

For investors, this hurts earnings and reported reserves for E&P companies in high-cost plays. While this can apply to deepwater or heavy oil projects, it is particularly true in US shale because of how reserves are booked, he said. Lower prices can depress two key measures of credit worthiness: cash flow and the value of oil and gas reserves.

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A survey of those in exploration and production in the US states, including Colorado and Oklahoma, found they are feeling more pressure from lenders and expect that will result in increased numbers of acquisitions and failures this year. Courtesy of the Federal Reserve Bank of Kansas City.

 

Because reserves are based on how much oil and gas can be profitably produced, companies in plays where the cost of adding production is greater than the current value of oil and gas are facing reserves reductions and impairments, which is the term used for reductions in the value of oil based on formulas used by lenders to evaluate loans.

“Impairments are more likely to occur first in areas with higher costs and lower margins, which is why the North American unconventional and heavy oil assets are particularly vulnerable,” Cunningham said.

Gaffney, Cline, & Associates’ model of the Eagle Ford shale concluded that only two out of 10 major operators in the south Texas formation were making a profit on new wells last fall. For the majority of them, the break-even price is more than USD 50/bbl. Last fall, lower prices led to reduced reserve values for about 75% of the companies working there, he said. Since then, prices have fallen further, adding to the pressure from investors and lenders to take action.

“If 75% of the companies were negatively affected by evaluations last fall, and (there are) more to come in the spring, I would think a lot of them would be either selling or not spending,” he said.

The corrective actions can range from refinancing or selling assets, from selling the company to filing for bankruptcy. But so far, there has been little action. “Take away a few mega-deals and 2015 would be characterized as a down year, when there were more potential buyers than sellers,” Cunningham said, adding “that condition could be reversed in 2016 as more companies will be forced to consider offers.”

Corrections Coming

The need to act will be strongest for those lacking the cash flow, or the ability to raise the money needed to continue operating. Those with insufficient cash flows can expect a chilly reception from lenders. Financial players with money to invest are taking a harder line than they did a year ago when investors bought billions worth of stocks and bonds from US unconventional operators. Weak companies “will be subject to predatory offers,” he said.

Signs of the transition are comments from executives in investor conference calls about the importance of limiting investment to the amount of cash generated by operations, and announcements of debt exchange offers by companies proposing deals to investors hoping to extend the due date on loans and perhaps reduce the amount owed.

They are responding to lenders whose measures of loan risk have surged. Gaffney, Cline describes it as a three-step process:

  • In the spring of 2015, companies and lenders waited to see if lower oil prices would last long enough to require reductions in reserve estimates used for financial reports and lender evaluations.
  • The next step came in the fall of last year when lenders began to reduce the borrowing bases—the formula that includes reserves used to evaluate loans on the books—and the vast majority were “negatively affected” by this process.
  • Finally, this spring comes the answer to the question: “And then what?” At that point, the pressure to act will likely begin to thaw the freeze in deal making.

A survey of energy executives last fall by Ernst & Young found that 88% expected the oil and gas deal market to improve over the next 12 months, and 59% of them expected their companies to close acquisitions over the next 12 months, which is double the response from a survey conducted 6 months earlier.
Lenders have proceeded cautiously because of the magnitude of the losses that could be triggered by an aggressive move to demand payment on all the loans where borrowers are not complying with the terms. But the level of impairments was huge when oil was trading around USD 50/bbl, and it has fallen from there.

“The number and volume of them is huge compared to any prior year,” said Paul O’Donnell, principal equity analyst for consultancy IHS. Three-quarters of the companies surveyed by IHS were affected, for an industry total of USD 100 billion in reduced value.

Late last year, some asset deals began to occur. Companies with high debt loads were beginning to work with bondholders to restructure debt. O’Donnell said that at the time most were small companies, though the problems now are more widespread.

One source of cash flow that sustained the industry in 2015 was hedging. Last year, many US independents used futures and options contracts to lock in prices for a relatively high percentage of their production at around USD 90/bbl.

This year, only about 11% of the production of a group of 48 North American independent E&P companies surveyed by IHS was hedged. Those hedges will pay less because they are locking in an average price of USD 69/bbl. “Going into 2016, it is more important than ever to be well hedged. It is lower than where you want to see it,” O’Donnell said.