In life, it’s sometimes hard to identify the tipping point that made a difference in the outcome of an event. A little more leeway in one direction and the result might have been success; a little less, and the outcome might have been failure.

The outcome for an E&P company riding out a prolonged commodity downturn may carry similar consequences. And when the downturn is projected to be as harsh as the current one, with “lower for longer” the mantra of the day, slippage one way or the other may be fateful—if not fatal.

If luck is not on your side—say, you didn’t get that financing off before capital markets shut down, or maybe you didn’t get a planned hedging program in place in time—your company could land in the hospital ward for an indefinite stay. As one observer quipped, the issue may then turn on “whether you need a lawyer or a priest.”

So what’s the outlook for the industry amid conditions where some E&Ps confront looming liquidity issues, often involving borrowing base redeterminations and restructuring efforts, while others wait with cash on the sidelines to take advantage of whatever opportunities arise?

Having experience as both a lawyer and geologist, BakerHostetler partner Michael Joy is well-positioned to offer insights on the downside and upside in the current environment.

With the oil price down more than 50%, hedges rolling off and options looking increasingly bleak for debt refinancing, there is a rising incidence of E&Ps facing the “zone of insolvency,” the term used by courts to describe the period when “a corporation is in financial distress, but it is unclear if it is actually insolvent,” according to Joy.

Insolvency is said to occur, he noted, when a corporation is “unable to pay its debts in the normal course of business,” or when its “liabilities exceed the reasonable market value of its assets.”

On the other hand, for those flush with cash, such as vulture funds and others knowledgeable about buying E&P assets out of bankruptcy, opportunities may be beginning to emerge and ramp higher.

“This price correction is going to be a once-in-a-career type of opportunity to buy assets,” said Joy. “I think you’re going to see more wealth created out of this event than you’ve seen in the last five years.”

Borrowing base resiliency

Which strategies can E&Ps use to survive tightening liquidity? For the more levered, the options are narrowing—absent a rebound in commodity prices—as banks redetermine borrowing bases against a backdrop of expiring commodity hedges.

In addition, although first-half 2015 equity raises and the follow-through of higher capex from 2014 helped augment reserves for the fall redetermination season, the spring 2016 redeterminations will likely reflect a run-off in reserves, as E&Ps have cut capex in line with lower cash flows in the latter part of 2015.

At press time, part-way through the fall redeterminations, borrowing bases appeared resilient. With results announced from 25 independent E&P reviews, a study by Robert W. Baird & Co., for example, indicated a modest 6% borrowing base reduction to an aggregated $21 billion from a prior $23 billion. A frequently cited expectation going into the review process was that borrowing bases would decline more, by 10% to 20%.

The spring 2016 redeterminations are expected to be significantly tougher unless commodity prices strengthen by then. Of note is a shift in policy by the Office of the Comptroller of the Currency (OCC). Previously it focused on reserve-based lending (RBL) by banks to the energy sector, but it has now decided to consider banks’ exposure to E&Ps’ overall enterprise risk, looking at total leverage, including second lien, high yield and other junior debt. By this measure, currently performing RBLs can in certain cases be subject to credit downgrades. (For more, see “A Conundrum for Energy Lenders,” Oil and Gas Investor, October 2015.)

For now, the banks have taken action to help stabilize E&Ps’ liquidity by setting aside capital of their own, according to a research note by Jefferies. In addition to giving E&Ps more time to improve their financial health, large banks lending to the sector “seemed to have set aside more capital to protect for loan losses to maintain liquidity for customers,” the Jefferies report said, noting just a 2% decline in aggregate borrowing base capacity for the 25 E&Ps it covered.

However, while large oil and gas lenders have pointed to the historically small losses on their RBL activity—secured by a first lien on the E&Ps’ proved reserves—pushback against the OCC won only “mild concessions” for the banks, according to Jefferies. “Lenders have clearly been forced to set aside more capital to provision for greater risk in RBLs.”

In addition, covenants have been tightened. According to Jefferies, banks have amended most secured loans to include new or modified restrictive covenants. Of note is the wider use of “secured” debt-to-Ebitda covenants, with a common prescription of no greater than 2.5 to 3.5 times. Banks have also added new interest covenants that typically permit no less than 1.5 to 2.5 times coverage, Jefferies noted.

Alternative sources

What if an already stressed balance sheet is, realistically, unlikely to pass muster with banks that are now subject to the OCC’s more exacting scrutiny? In terms of alternative financing, according to Joy, one option that shouldn’t be overlooked is European and Asian funding—and, in particular, European sources facing domestic interest rates that are at negative or near-negative levels.

Not subject to OCC supervision, European capital can in some cases be accessed for around 6% through a similar first lien on proved reserves. Specifically, Joy cites private wealth managers in Switzerland—akin to family offices in the U.S.—as a funding source in amounts generally not exceeding $50 million.

“I’ve definitely seen and heard from different groups out of Europe,” said Jeff Huddleston, managing director in Houston with restructuring and turnaround specialist, Conway MacKenzie.

“Sometimes they have paired up with knowledgeable former U.S. brokers that put together deals sourced from the U.S. with capital sourced from Europe. With some, we’ve got to the point where we have a higher degree of confidence they can get a deal done; with others, we’re not so sure.”

Of course, the “lower for longer” trend is taking its toll not only on smaller players but also on a number of larger, more levered E&Ps that depend on much more substantial financing. Increasingly, they have to pursue strategic initiatives in terms of new financing sources and restructuring of existing debt.

A recent example of such debt restructuring was the announcement by Exco Resources Inc. in October of debt transactions with its existing bondholders and Fairfax Financial Holdings Ltd. Exco reduced its total debt outstanding by about $270 million, or 18%, in part by repurchasing $577 million of unsecured notes for $291 million.

In a series of transactions, Exco issued to Fairfax Financial a $300 million senior secured second lien term loan, which had a five-year maturity and came at par with a 12.5% per annum interest rate. These proceeds would be used to pay down a portion of its revolver borrowings.

In addition, it reached agreements with certain noteholders to exchange $577 million in unsecured notes for a $291 million senior secured second lien term loan, effectively repurchasing the unsecured notes at an average price of 50.4% of the notes’ principal amount. Holders of the $291 million secured loan were granted a pari passu position with Fairfax Financial, holding a second lien security in the same assets, and likewise receiving 12.5% per annum over a five-year term.

Also, Exco said it would repurchase approximately $376 million of its 7.5% senior unsecured notes due 2018 (50% of the $750 million outstanding) and approximately $201 million of its 8.5% senior unsecured notes due 2018 (40% of the $500 million outstanding). The company noted this reduced the principal amount of unsecured notes by $577 million, or 46%, with the amount of the nearest unsecured debt maturity, due in 2018, decreasing by half, or $375 million.

Post-restructuring, Exco reported a reduction in its borrowing base to reflect the incremental secured debt it had taken on. “We see this borrowing base reduction as more than reasonable given that Exco is adding $591 million in incremental secured debt,” commented RBC Capital Markets in a research note.

In early November, as this issue went to press, Exco announced a second round of debt restructurings.

Nonbank sources

Such restructuring moves—whether accessing new capital or offering to exchange new debt for outstanding issues being repurchased—are no easy undertaking in today’s illiquid capital markets.

“The energy capital markets, particularly for all but the largest and healthiest companies, are in our view now so illiquid that investment bankers are reticent to offer highly confident financing indications, making for an environment in which ‘clubby’ and highly negotiated financings are becoming the new normal,” said Todd Dittmann, who leads the energy team in Houston for Angelo, Gordon & Co.

“This is a shift in focus and dialogue toward the few remaining active energy lenders and away from the prior, broadly syndicated process focused on numerous, enthusiastic capital providers.”

In retrospect, the shift in OCC policy came as a “rude surprise” to borrowers and lenders alike, who had become accustomed to the sequence of E&Ps first accessing bank credit and then issuing high yield and convertible securities, said Dittmann.

“No one thought the regulators would come around and say, ‘We’re going to score these loans on the basis of total leverage and not first lien leverage.’”

Going forward, as expiring commodity hedges lead to lower anticipated well economics by way of eroding prices, declining volumes and reduced net present values (NPV), the increasing stress on E&Ps’ balance sheets and the increasing incidence of covenant breaches are likely to generate greater demand for nonbank capital, said Dittmann.

Borrowers stand to benefit in that “nonbank capital doesn’t expose them to the vagaries of the semi-annual sole discretion borrowing base, a mechanism that can be equivalent to a recurring six-month demand note when commodity prices turn south.”

Nonbank lenders, according to Dittmann, “play a very valuable role in providing transitional capital at the very time ‘regular way’ capital seeks to exit, as well as providing a bridge to the other side—whether that outcome be an oil and gas price recovery or industry consolidation.

“If management teams have identified acquisitions, or are convinced that their projects are still attractive, or that prices will eventually increase, the value of this capital is substantial, given the runway and lease on life the borrower gains as compared to prospects of borrowing base reductions, tightening covenants and six-month forbearance periods.”

And in terms of human aspirations, nonbank capital may have more to offer. “Typically, these are very talented management teams,” added Dittmann, “and working for the bank in a managed liquidation is a waste of their skills.”

The energy group led by Dittmann in Houston is focused on a senior, and typically secured, debt investment strategy, rather than unsecured debt or equity positions. Positions are selected that offer good asset coverage. In the event of a commodity price recovery, the normal course of events would be for E&Ps to refinance the debt on more attractive terms, including the banks resuming their funded RBL relationship.

The tone has changed

For E&Ps already verging on liquidity issues, the corridors of restructuring and turnaround firms in some of the key energy centers are becoming more crowded.

“We’re very busy right now,” said Conway MacKenzie’s Huddleston.

Whereas a naturally optimistic oil and gas sector carried with it a “this too will pass” attitude in the first half of this year, a tone of greater urgency has developed in recent months, he said.

“It’s an optimistic industry. A lot of guys thought this was just a short-term blip,” recalled Huddleston. With plenty of new capital—some from nontraditional sources—coming into the sector in the first half of the year, “we really didn’t see a whole lot of activity. We weren’t getting signed up for a lot of heavy restructuring. Now we’re in the middle of the second half, we’re seeing a bit of a different tone.”

Blame that on a number of factors, including the impact of loan covenants and expiring commodity hedges. “Previously, people weren’t as close to the margin on loan covenants; and, with hedges, the full pricing impact hadn’t hit their borrowing bases yet,” Huddleston said. Also, if E&Ps were already over-levered, or had higher cost operations, whatever safety net they may have had in terms of cash was rapidly depleting in the lower commodity price environment.

Timing and cash

What are some key behaviors to avoid if an E&P realizes it is at risk of sliding down the slope to insolvency?

“The most frequent mistakes, making situations go from bad to worse, are waiting too long and placing too much reliance on just one or two particular solutions, such as a ‘white knight’ capital provider that’s going to come in and take out your existing lenders and give you some drilling capital—the ‘saving-the-day’ sort of capital provider,” said Huddleston. “You can’t wait too long in hopes there is something like that waiting in the wings. You have to be very realistic.

“Importantly, you have to do something while you still have cash—cash is king. That’s probably one of the biggest pivot points as to whether you can save a company. If you’re bleeding cash, you only have a certain amount of runway to pursue different options.”

Those options may include a strategic merger, takeout financing, new capital, recapitalization or an equity infusion. “But those all take time,” he said. “Time is on the other guy’s side, and they’ll use that to their advantage to cut the best deal. For the optimal solution, you have to have cash and be able to maneuver and preserve optionality.”

For those lacking adequate cash—and perhaps already sliding into insolvency—Baker Hostetler’s Joy offered additional guidelines pertaining to tightening cash balances. Directors’ duties have shifted such that they have an obligation not only to stockholders, but also to the “community of interests” involved in having helped create wealth, he said. This means directors shouldn’t take actions to increase stockholder returns by impairing creditors’ claims, and that one class of creditor shouldn’t be favored over another.

For E&Ps with more precarious balance sheets, there are alternative—but often more aggressive—financing sources to consider, according to Huddleston.

“There definitely are sources that are not scared away by stress,” he said.

In the event a deal doesn’t work out, they are prepared to take over the assets or fold them into another portfolio company. But in the interim, they may offer a lifeline, taking out the existing lenders and providing an E&P with a 6-to-12-month period for it to rationalize its cost structure and get production and cash flow back up. Servicing debt via PIK (payment in kind) in lieu of cash interest may also be a possibility.

This type of financing does not come without risk, however.

“Some of the more aggressive capital sources can offer much-needed breathing room on covenants and/or debt service requirements, and may be appropriately pricing an E&P’s cost of capital,” said Huddleston. “But you have to be aware of the milestones that make these deals work and make sure you don’t trip wires that could potentially lead to debt default. Otherwise, the consequences of not performing on these types of loans can be punitive longer term.”

Meanwhile, companies in stressed situations are frequently trying to stay alive by shedding noncore assets and, as far as possible, retaining their prized assets. But observers generally note a tepid pace in the transaction market to this point in the downturn, variously attributed to a still wide bid-ask spread, the quality of noncore assets for sale, a wait-and-see approach to larger asset packages due to come to market after the spring 2016 redetermination, and other factors.

“I think we’re still on the front end of bank-driven asset sales,” said Dittmann. “I think we’ll start to see more and more as the banks put borrowers on six-month plans to fix the borrowing-base breaches. I think asset sales, and particularly partial asset sales, are among the more obvious solutions for that.

“The interesting thing is that location matters more than ever. We are beginning to see a very bifurcated acquisition and divestiture market, in which some areas are hot and carry premium valuations and in which other areas fail to attract any buyers.”

Sales from companies that are in bankruptcy proceedings have also begun and are expected to increase. Here, much depends on several factors: the quality and location of the asset, the sophistication and knowledge of potential buyers; the level of interest in Chapter 11 bankruptcy (so-called 363 sales); and the vagaries of the sale process itself.

“A lot of bidders have told us, ‘We just don’t participate in 363 sales.’ So, once you file for Chapter 11, you eliminate some subset of your buyer universe right there,” said Huddleston. “On the flip side, it can also be a very inefficient market. If you get just one or two knowledgeable bidders who know the assets very well, you can pick assets up at a very attractive price.”

In terms of bank-driven sales and 363 sales, the cup also looks more than half-full, according to Joy. With a “dearth” of bankruptcy experts in the oil and gas sector, coupled with “tremendous value in the 363 process if you can handle the hair,” Joy predicts “a bad time for some, but sub-$50 oil is creating a new generation of opportunity.”