Quotes for WTI crude oil fell below $36 a barrel in early December, further dashing hopes for a quick rebound in the oil and gas (O&G) industry. As the downturn in crude prices drags on, energy producers are under increasing cash flow pressure, and more face going concern uncertainties.
Yet, U.S. shale oil output remains at high levels, and there may be little contraction in 2016
. Many companies have stayed afloat and kept producing by becoming more efficient. As discussed in the 2015 Grant Thornton LLP survey of U.S. oil and gas companies
, they have cut costs, adopted tax strategies, and introduced new technologies.
It’s important to note that producers have been sustained by the energy sector’s ability to secure capital. Kevin Schroeder
, industry managing partner for Grant Thornton’s Energy practice
, explains how capital availability has meant fewer company failures than anticipated, at least up until now:
“Compared with the 2008–09 cycle, producers have relied less on traditional bank credit facilities as they were able to take advantage of more attractive capital and other forms of debt in capital markets. But one of the greatest changes since 2008 has been the money from private equity (PE). Since 2012, probably more than $100 billion in PE has been put into the energy industry, and there continues to be a similar amount on the sidelines dedicated to the industry. Those capital resources, coupled with the willingness of banks to work with producers during this downturn, have allowed many companies to survive. But with continuing low prices and hedges coming off, we will see more stress and challenges with liquidity and capital resources.”
Since summer 2015, few energy companies have been able to raise money through public offerings
. But there have been a few positives. The banks’ fall 2015 review of producer credit lines resulted in fewer cuts than had been expected
. The energy industry continues to be one of the leading targets for PE. And even deeply troubled companies may find rejuvenation in the salutary provisions of U.S. bankruptcy law. Overall, capital access represents a key driver to a company’s survival and/or success.
Energy survey results
The recent Grant Thornton survey sought information about capital considerations, availability and resources for energy companies.
Terms and conditions are the major capital consideration
Asked which capital considerations have the greatest impact on their strategy, “terms and conditions (private debt, private equity) and the impact on organizational control” garnered the strongest response (44%). Three factors were close runners-up: access to necessary capital (37%), determining the right mix of capital sources (33%), and internal hurdle rates (31%).
“Those three factors have historically been important considerations, so it’s not surprising they received high responses,” says Bryan Benoit
, Grant Thornton partner and U.S. Energy Advisory leader. “What is
interesting is that the top vote recorded was for terms and conditions. Companies trying to raise capital are increasingly concerned about their capital structure — specifically the mix of debt versus equity — and the terms of the agreement, such as debt covenants and convertibility. When surveyed in July 2015, companies may have been anticipating a further downturn that made them cautious about such terms, which wouldn’t necessarily be top of mind in better economic times.
Benoit notes that more deals are getting done where the financing is neither all debt nor all equity; there is (a) debt that is convertible into equity, or (b) a mix of debt and equity financing. “Right now there is great uncertainty about the next direction the energy industry will take,” he says. “Banks, private equity and other financiers are creating elaborate structures that enable them to create a unique risk profile for their energy investments that neither conventional debt nor equity arrangements would allow.”
Capital is becoming more difficult to acquire
More than one-half of respondents said capital was either slightly more difficult or much more difficult to acquire in 2015 than in 2014.
“The amount of investment capital available to the industry remains large,” says Benoit, “but there must also be adequate returns. Interest rates are anticipated to increase, but they are still very low relatively speaking. Even though the cost of capital available to many companies might not be prohibitive to growth, there are fewer energy companies that can provide required rates of return.”
Cash flow is still the most important source of funds
Questioned about the sources of capital their company primarily accesses, more than one-half (58%) cited cash flow from operations, while commercial bank debt, private investors and private equity were each mentioned by about one-third of respondents.
“Cash flow from operations may be lower now than when the survey was taken in July 2015,” says Benoit. “Being self-funding is a nice luxury for companies, but difficult to realize given the industry economic conditions we have today.”
Benoit says that the borrowing base resets by banks in October had far less of an impact than some had anticipated. Ultimately, bank managements have limited choices regarding troubled energy loans: they don’t want terms that force companies out of business. But with regulators fearing banks’ overexposure to the O&G industry and commodity prices remaining depressed, some institutions may be compelled to take a tougher position toward their energy loans in 2016.
According to Preqin, as of early December there was some $126 billion in dry powder available for investment by equity-focused funds. The number doesn’t include the tens of billions of dollars available from generalist funds, notes Grant Thornton’s Andrew Kahn, director in the Private Equity
practice. “Given that energy, along with health care, are the two leading focal points of private equity, the amount of available capital when generalist funds are included is significantly larger than that from energy-focused funds alone.”
Kahn says that energy is an area where much mispricing can be seen, and that’s typically what the smarter PE investor attempts to leverage. “There’s a bit of a gold rush for O&G companies,” he says. “Energy is distressed right now, so it’s going to get a lot of attention from PE over the next few years.”
Business models for PE energy investments
PE investment in O&G often breaks down into two models. Under “lease and drill,” the PE firm acquires land and drilling rights and leases them to a producer. Kahn says, “With this model, there’s not much involved. You’re not running an operation; you’re not looking at, say, developing new fracking techniques to get more product. All you’re doing is letting some company pay X amount of dollars to muck around on your land for a certain length of time, with or without a revenue-sharing agreement.”
In the acquire-and-develop model, however, the PE firm has a more hands-on approach and exhibits more control. Kahn comments: “Here you’re taking a smaller piece of land and trying to get every bit of exploitable value — the combustible energy, the byproducts of that energy, the equipment you develop that you may be able to patent and sell to others, and so forth. PE is hiring bigger benches of more specialized people to do these kinds of operations.”
Recommendations for energy companies
What advice does Kahn have for energy companies that may be contemplating PE as a source of capital? “Remember that PE has a wide variety of investment models. If you’re a distressed company, you’ll find a reasonably large proportion of PE firms are interested in distressed situations. Focus on them. Importantly, the kinds of investments a PE shop is interested in is usually public information, i.e., it’s easily accessible. You can call a PE shop on the phone and find out if they do the kind of deal your company may present.”
The professionalization of private equity helps energy companies
Private equity funds have changed vastly from the 1980s, when many were involved in hostile takeovers of public companies through leveraged buyouts.
Today, PE typically takes control of an existing business and holds it over a period of five to 13 years (funds are typically chartered for 10 years with three one-year extensions). Compared with the 1980s, PE funds are now much more likely to retain existing management. Over the holding period, PE makes capital and operational improvements, seeking to generate sufficient income to cover operating costs and meet its internal rate of return commitment to investors. PE then exits the business through various strategies, often a sale to a company in the industry or another PE firm.
“There’s now about 3,500 PE sponsors in the U.S., compared with just a few hundred in the 1980s,” says Kahn. “Back then, it was a very insular business — nobody knew what the other guy was doing. Over the years, the industry has accumulated knowledge and techniques to know what works and what doesn’t. A few of the larger PE groups are now publicly traded, so they have to be forthcoming about the way, what and why of their activities. Many of the younger firms have copied the best practices of the big firms: they’re asking a broader variety of questions and answering them in more formal ways. Essentially, what you have is the professionalization of an industry that can be very clever in designing ways to help companies. Pursuing its own goals, PE has become an important alternative for companies that need to acquire working capital.” Restructuring and bankruptcy
The continued low-price environment raises the possibility of liquidity problems that will require more companies to consider reorganization in bankruptcy. “I do expect to see more restructurings in the O&G sector,” says Ryan Maupin, Grant Thornton director, Corporate Advisory & Restructuring Services
. “We’ve seen other industries go through changes like the one O&G is going through now. Something fundamentally changes the landscape, forcing companies to adapt in order to stay relevant. Companies with stronger leadership, better organization, more preparation, and healthier balance sheets will be the ones who survive in this downturn. As the downturn continues, aside from weaker companies failing completely, we expect to see more divestitures, as well as in-court and out-of-court reorganizations and recapitalizations.”
Maupin says troubled companies often make things worse by waiting too long to seek help. “Companies sometimes wait too long before they feel it’s time to contact restructuring professionals. Companies that can address performance problems when they start appearing on the income statement usually have more optionality on possible remedies. When companies wait until these performance issues have started to affect cash and working capital, this optionality lessens, obviously. During these downturns, management needs to be preparing for different scenarios and openly asking the what-if questions: What happens if one of our key customers goes bankrupt? What happens if we see significant price and volume drops? What if there’s a borrowing base reset? The ability to forecast the liquidity impact in these scenarios becomes very important.”
Advice for companies considering restructuring
For those companies whose deteriorating liquidity position makes some form of restructuring inevitable, Maupin has the following recommendations:
Using reorganization for a new start
Understand liquidity position and build a short-term forecast if not already developed.
Maintain transparency with key parties in interest and make sure you engage early with secured lenders.
Choose professionals who have bankruptcy and specific O&G industry experience. “O&G bankruptcies have a host of industry-specific issues that require special attention and planning,” says Maupin. “Mineral leases, royalties and access-to-land questions specific to O&G companies need to be understood completely. In addition, certain state statutes in Texas and Louisiana can add another level of unexpected complexities.”
The type of adviser you will ultimately need is context-sensitive to each company’s situation and respective objectives. When it comes to financial advisers, interim management professionals or investment bankers, it’s important to understand that different types of professionals (or a combination thereof) may be needed for different situations and desired outcomes.
Bankruptcy is a process that can represent a new start for the company. “In some countries, bankruptcy is only an ending,” says Maupin. “That’s not the case in the U.S. The bankruptcy code gives companies the opportunity to emerge with its balance sheet reorganized and operations restructured in a way that puts the company in position to return to profitability.”