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Exploration and production (E&P) investors have been in for the ride of their lives since the precipitous decline in oil prices started in the summer of 2014. To be sure, oil is a cyclical commodity that has always required investors to have a strong stomach. As the story goes – “high prices cure high prices and low prices cure low prices”. Having said that, this price correction has always made me a bit more uncomfortable than usual. As a commodity strategist, one of the first things I strive for during market extremes is an analog. While history is not perfectly repeated, it certainly rhymes. However, we have never experienced a cycle in U.S. shale oil. In short, there is no analog. Forecasting cost deflation, rigs to production and, ultimately, price and supply has become very difficult.
Consequently, the fundamental opaqueness of this cycle, coupled with the level of industry leverage, has led to outsized concerns that a massive fiscal crisis in the E&P sector would lead to a balance sheet-driven supply shock. While these concerns have eased since the market rally, Brexit (and its consequential price carnage) will undoubtedly reignite this concern. This article addresses these concerns and concludes that overall liquidity available to U.S. oil and gas producers remains strong. When looked at holistically, the net flow of capital to the sector should prevent a liquidity-induced supply shock, even if we retest the lows as a result of Brexit.
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- Projected liquidity outflow as a result of bankruptcies and reductions in commercial lines of credit is likely just shy of $60 billion.
- As of 1/1/2015, the realized inflow of liquidity via the equity market already stands at roughly $40 billion USD.
- A projected $100 billion in dedicated oil and gas private equity capital on the sidelines should ensure a net positive liquidity outlook for the industry until prices recover and cheaper forms of capital can be raised.
- The net positive liquidity outlook will ensure a slower, more moderate price recovery as capital will ultimately find its way beyond balance sheet repair to reserve and production growth.
Liquidity concerns will not portend a balance sheet-driven supply shock:
A bit on (the often-mentioned) bank E&P loans redeterminations……
Aside from the recent macro threat posed by Brexit, there has always been much speculation around the effect of redeterminations on E&P liquidity, solvency and, consequently, production in North America. While future redeterminations are sure to be more impactful due to relatively anemic hedge profiles, it should not be assumed that the outcome will be as cataclysmic as the market seems to expect. In fact, the mere assumption that redetermination outcomes are predictable should cause pause. Redeterminations are not nearly as programmatic or inflexible as perceived. The notion of a redetermination “season” is as misplaced as the notion that there is commonality in credit agreements. To be sure, collateral evaluations are not as static as April and October. In fact, most credit agreements allow lenders to evaluate collateral more than twice annually. Higher frequency collateral valuation over different time frames lends itself to less dramatic and more uniform reduction in capex. This intrinsically reduces the chance for a dramatic reduction in production at any specific time. It also eases producers into liquidity reduction as opposed to creating liquidity shocks.
Credit agreements are written to meet the specific profile of each borrower. Agreements can dictate spending caps on certain line items on the income statement and most certainly mandate specific hedging profiles based on the unique type curve characteristics of each producer. Unless there is a clear understanding of the specifics of each credit agreement, it is very difficult to determine the outcomes of future redeterminations other than to extrapolate from pending announcements. However, even this exercise is difficult given the aforementioned bespoke qualities of each lending relationship. Moreover, extrapolating upon redetermination results from 2015 can be equally misleading as hedge profiles were much different than they are today. While hedge books were considerably larger during the fall 2015 redetermination season, the forward curve has also rallied significantly. This is important to note as credit capacity can be as easily reinstated as it is taken away. Adding to the uncertainty is the fact that this is the first true economic cycle in the shale phenomenon. While it may be tempting to look to 2008 as an analog, we must remember that extreme fiscal and monetary measures were used to combat an unprecedented housing bubble. This event should not be confidently used to draw expectations around how this supply side price rout will play out.
However, there are other aspects of current market dynamics that can potentially assist in determining the likelihood of a liquidity induced supply shock. First, we can stop trying to look at credit availability on a micro level (which may be impossible) and start to look at liquidity on a macro level. If we were to look at the overall, NET capital flow in the E&P sector we may be able to get a more accurate, predictable picture.
We can first start by looking at all possible capital outflows from the industry. Immediate liquidity reductions can come in two main forms – bankruptcy and reductions in commercial bank lines of credit.
Since the beginning of 2015, there have been over 60 U.S. bankruptcies announced with obligations at risk totaling over 40 billion USD. The question then becomes – what is the likely outcome of these filings on future liquidity and capex? A key to answering this question is to understand the role or private equity/alternative funding players during bankruptcy, both as incumbent and new credit providers.
I believe that there is an incredible amount of incumbent private equity capital available to prepackage and pre negotiate reorganization plans that will more than likely swap debt for larger equity interests and even potentially inject more capital to take advantage of lower valuations. Incumbent alternative investors are likely to invest more for a larger equity interest at a lower valuation than abandon the investment for pennies on the dollar. In addition, new private equity capital will unquestionably enter the market at the most distressed levels to take advantage of the funding needs of companies that are unable to get more capital from banks. Alternative investors are in business to operate when traditional forms of credit are unavailable. They can demand better terms precisely because they are the only show in town, notwithstanding the fact that yield in other asset classes are paltry compared to the likely view that they are buying assets at the low end of the cycle. For example, take the case of Samson Resources. Samson filed for Chapter 11 protection in September 2015. Samson will continue operations because it is going to offer up equity in a restructured company to PE firms Silver Point Capital, Anschutz Investment Co, and Cerberus in exchange for debt absolution. Moreover, these PE firms have also offered to recapitalize the company with over $400 million in fresh loans.
There will be more than enough capital available to recapitalize a large percentage of bankrupt producers. In fact, the real issue for private equity is the competition they are seeing in their own industry to find and compete on deals.
Based on reviewing several private deals and having detailed conversations with large private equity sponsors, I believe that the actual capital at risk from bankruptcies will be closer to 20 billion when all is said and done. Even though private equity sponsorship has been relatively muted thus far, it should be highlighted that bankruptcies have not had a material impact on U.S. production. The company’s filing are simply not volumetrically significant. Moreover, bankruptcy protection has enabled producers to focus and maintain profitable assets resulting in continued production.
*Filings since the second half of 2015 in excess of 250 mln in liabilities