At What Price Capital?

Given how much money institutional investors lost last year in the oil and gas sector due to a significant commodity price decline, it was expected that capital markets would be closed for the bulk of this year. But, overwhelmingly, observers have been surprised at how supportive capital markets have been year-to-date.

“The capital markets are wide open and continue to be,” said Nathan Craig, managing director with J.P. Morgan. “Investors found, given where equity levels were trading, that there was a certain amount of money to be made.”

A wave of successful equity issuances by upstream E&Ps in the spring broke the winter ice that had frozen the markets previously, and three-quarters of all issuances this year to date have exceeded the EPX index, Craig said. “Institutional investors that did put money to work in a majority of these equity offerings have made quite a bit of money.”

A stabilized commodity price backstopped that confidence, but Wells Fargo Securities’ James Kipp, head of energy and power, investment banking, said also those same investors have reacted positively to the rapid adjustments E&P companies made to their cost structures. In many fields, they have been able to make economics work at oil prices in a range of $50 to $55.

“Investors look at it as an opportunity to get in at—if not the floor—at least near the floor,” he said. “And there’s a tremendous amount of upside associated with an improvement in commodity prices.”

However, when it comes to accessing public capital sources, not all E&Ps are equal in investors’ minds, said Dennis Petito, Credit Agricole managing director, head of North American energy.

“While those sectors tied directly to commodity prices are experiencing modest increases from their lows earlier this year, the market seems to be able to make intelligent decisions about who are the stronger players and who are the weaker players.”

The number one thing institutional investors are focused on right now is cash on cash returns, and trying to get a true sense as to the internal rates of return on these wells, said Craig. The investor base has spent the time understanding the difference between the plays, and what is truly core acreage versus tier one or tier two.

“Institutional investors might be more wary than they were historically about what is the true all-in IRR at the well head, and if that can be applied across the entire acreage position. There is a willingness to play in those management teams that continue to deliver what they say they can.”

Yet even the weaker players have access to capital, Petito pointed out, but at a price.

“Companies with a significant amount of leverage are going to have the least ability to tap those sources at a favorable price. We’ve seen a number of transactions involving nontraditional sources that demonstrate there is liquidity and availability for a price. Whether a company is willing to pay that price is a strategic decision on the part of that company.”

High yield

Although the high-yield markets were slower to warm than equities, that money has returned, albeit with caveats. “It’s a very selective market,” observed Kipp. “There is still a bias toward single basin vs. multibasin stories.”

That, as well as an investor focus around the economics associated with various regions, particularly as it relates to multiple commodity price scenarios. “If you’re looking at a $50 case, a $60 case, or a $70 case, what do the economics do?”

“Naturally, you have more yield required to get transactions done than you did before, but [the market] absolutely remains open,” said Nathan Craig, J.P. Morgan.

J.P. Morgan’s Craig illustrated the company’s E&P high-yield index is a bit over 9.3%, compared to its broader high-yield index of 7%.

“Before the oil price decline in August last year, both indices were on top of each other,” Craig said. “The market is requiring a higher yield for E&P issuers than they had prior to the price collapse, so there’s a little more yield in high yield today.”

That trend is fueled by opportunistic money, he said. Since the commodity price decline, a flood of capital has come into and is now circling the energy space, supplied by institutional investors that haven’t historically invested in the oil and gas landscape.

“When they saw the significant value deterioration, it attracted a lot of people that hadn’t played in the space, and they spent their Christmas vacations getting educated on the space in order to be able to play it this year,” said Craig. “Naturally, you have more yield required to get transactions done than you did before, but [the market] absolutely remains open.”

Companies with stressed balance sheets have access to this capital as well, said Kipp—with a twist.

“We’re seeing some high-yield deals being done that are not the traditional types of high-yield issuances straight down the fairway like you would have seen 12 to 24 months ago,” he said, noting shorter tenors and additional covenants becoming more commonplace. But the types of capital have evolved as well.

“It’s more difficult to access that market now than 12 to 18 months earlier, but that’s been to some degree supplemented by the second-lien market, the Term B market, and many of the mezz investors. It’s not like you have only two capital sources—bank financing and high yield. You have numerous pockets of capital that are available.”

Second lien

Over-levered companies are issuing more second-lien paper, Credit Agricole’s Petito noted. “That’s certainly been available, but somewhat reluctantly.”

That’s because second-lien paper immediately subordinates existing unsecured bondholders, and thus stresses how that existing paper will trade. Some companies with a choice would prefer to pay more and issue unsecured debt to retain that relationship with current investors, but the second-lien issuers often do not have that choice, he said. In cases where it’s been used, the second-lien issuances have served to replenish or, in some cases, replace bank facilities, providing the liquidity needed to get through a rough period.

“If you really need the liquidity, then you’re going to pay the price,” Petito said, “because the alternative is you don’t have the liquidity, and you’ll be looking at some difficult financial decisions later.”

Investors, too, are looking to take advantage of this trend, said Craig, especially current bondholders caught in the slide.

“Existing investors are doubling down on certain names, and they’re doing so by moving up the capital structure. We’ve witnessed some investors willing to participate in debt-for-debt exchanges, and debt-for-equity exchanges. They’re doing that in the form of moving from an unsecured to a secured position, or into second liens” to mitigate any potential loss in a default situation.

“We’re seeing some high-yield deals being done that are not the traditional types of high-yield issuances straight down the fairway like you would have seen 12 to 24 months ago,” said James Kipp, Wells Fargo Securities.

Debt for debt

Debt-for-debt swaps are gaining popularity alike for both financially stressed operators and their exposed bondholders, but each transaction is unique. One thing is consistent: debt holders swap out of one series of bonds for a different structure, usually into a better position.

“If the company comes out with a new issue at a higher rate or higher up the capital structure, there is a willingness for some existing institutional investors—even if their original issue is trading below par—to double down or put additional money toward the new issue to give the management team time to execute the plan,” said Craig.

That willingness to double down typically is a sign investors believe the management team has the ability and the assets to get substantial returns on the capital invested.

Wells Fargo’s Kipp explained that unsecured bondholders with debt trading at 60% of par, typical of the current market depending on the issuer, might approach the issuer to redeem at 80% and take new, secured paper in exchange for the haircut. The company, in turn, receives a 20% reprieve in debt relief. “You get an immediate pop.”

Another reason these are occurring? “There is more liquidity in bonds now,” he said, referring to distressed funds targeting distressed paper. “There are more high-yield investors and a large pool of capital that is active in acquiring that paper.”

Petito suggested that some investors are even willing to “PIK” the new debt to boost liquidity to the client. That is, a payment-in-kind whereby some or all of the interest payment is deferred for up to three or more years, during which time it accretes to principle.

“The bond will probably accrete back to par, and you’ll have a higher rate on top of that,” he said. “It’s not a bad trade if you’re a creditor.”

And frankly, he added, “if you’re the debtor, it’s not a bad trade either, if that’s what you need to do to keep developing those properties so you can create more value.” Although the coupon might be as high as 12% to 13%, “if you can invest the proceeds into PUD locations that have a 30% or greater IRR, why not do that? It makes sense.”

“We’re seeing some high-yield deals being done that are not the traditional types of high-yield issuances straight down the fairway like you would have seen 12 to 24 months ago,” said James Kipp, Wells Fargo Securities.

Debt for equity

So far, the number of investors willing to trade out their debt position in the E&P sector for a payout in equity has been sparse, but Wells Fargo’s Kipp sees this as a potential liquidity solution in the second half of the year.

To make this trade, an unsecured debt holder must be convinced the value of the company—in the case of default—would not be enough to cover the secured first and second lien lenders ahead in line, plus their position. Exchanging the debt for shares thus relieves the operator of the financial burden, creating a better chance of survival, and provides the bondholder an opportunity to profit from any increases in equity valuation. The company must be willing to dilute existing shareholders for that liquidity.

“The unsecured debt holder needs to figure out if it makes more sense to convert into equity to provide the company relief, and hopefully enough support by not having to pay the interest around that debt, and does that provide an ability to generate additional liquidity to work out of that situation?” Kipp said.

Many times such debt-for-equity exchanges don’t provide enough liquidity relief, and are often accompanied by an additional influx of new capital by the investor, he noted.

Yet trading debt for equity tends to be a solution of last resort for investors because of simple gamesmanship, Craig postulated. “If everybody but you swaps debt for equity, then your credit position is enhanced and you are more senior in the capital structure. Everybody else is waiting for somebody else to do it.”

The flipside, said Petito, is that unsecured investors are left exposed as the ship lists. “At first glance it’s seen as a restructuring, but once you begin to see the impact it’s going to have, both as a creditor and the debtor, and run it through your models, it sometimes makes sense.”

More and more of these are taking place, some currently outside the public eye, he said, “and I think they are very good trades. We have situations where companies are biting the bullet and issuing equity, and there will be more.”

IPOs

In the meantime, while midstream IPOs seem to have the all-clear, E&P IPOs are in an indefinite holding pattern, with none coming to market year-to-date. Kipp estimates five to 10 were backlogged from the end of 2014, and various other private-equity portfolio companies are ripe for an exit, he said.

“We’re talking to a number of them now.”

Rather than trust the markets solely, Kipp reported that new issuers are currently preparing a dual tract: planning to file an S-1 to test the public market, but also exploring bids on an outright sale simultaneously. He expects this dance to occur during the second half.

Craig indicated some potential IPO issuers might rein in their expectations of going to market once bankers revise their NAVs and indicate an issuance price.

“Owners are going to have to make a decision as to what the IPO issues might look like, and whether they’re willing to entertain that or just hold onto the asset base a while longer.”

That’s because investors are looking long and hard at whom they’ll back: the classic fantastic returning asset base, proven management with an excellent record, and limited leverage on the balance sheet. “Whoever goes first will have to meet those significant hurdles to reopen that market.”

On a positive note, “With the good money investors have made buying into these follow-on offerings, there’s an argument to be made that you can make money off of new issuance.”

Said Kipp: “Get everything in place and be ready, and when the window opens, move quickly. Don’t hesitate; windows open and shut quickly.”

Looking ahead

In the fall, bank borrowing base redeterminations could motivate companies to access capital markets in advance. On average, borrowing bases declined by 5% to 15% in the spring, but hedges rolling off and reduced rig counts could bite into the base further this fall, said Craig.

“If they’re not replacing PDPs at the rate they were historically, and their hedges are rolling off, you might start seeing a material decline in borrowing bases.”

Yet Craig sees a bounty of liquidity being made available to the energy space by large funds to bridge this gap, crossing the entire capital spectrum.

“We see a tremendous appetite from banks and institutional investors,” he said. “You’re going to see a lot of capital deployed. No one is exiting; they’re bringing more to the table.”

Kipp foresees borrowing base redeterminations and A&D opportunities re-igniting equity issuances during the latter half of 2015. “There may be a second round coming,” he said. “Companies with relatively strong stock will likely build a war chest to take advantage of opportunities.”

Petito tips his hat to the flexibility of U.S. producers in the face of a 50% reduction in oil prices.

“They’ve been able to get their arms around an extraordinary crisis situation, in a very short space of time, and take steps that enable them to continue to operate, invest and gain returns that are substantially higher than what it is costing them to receive that extra capital.

“They may not like it, but they know they have to do it. It’s an extraordinary commentary on the sophistication of the management teams that are making these decisions.”