Debt Wars

The trend of the five-year strip from 2004 through March 2009 reflects the commodity-price collapse, which has left leveraged producers in a situation akin to that of the late 1990s.

?In early 1997, the price of oil looked pretty good, trading in the range of $23 to $25 per barrel, after having languished in a band of $15 to $17 for much of the previous 10 years. The five-year strip on March 31, 1997, was about $21.

Many independent producers were using these greatly improved economics to aggressively grow their assets and production volumes. Development of the high-yield debt market in the early 1990s coincided with this trend, and the major Wall Street junk-bond houses descended on the oil and gas industry to help finance its growth plans.

Approximately two dozen high-yield debt deals for energy were done from 1995 to early 1998 and the banks aggressively financed acquisition and development programs as well.

At the time, the preferred business model was to acquire and exploit new properties or develop legacy assets, using aggressive debt offerings and bank deals as bridge loans to a public-equity offering. Once a company realized the full potential of key properties, it was believed that the equity markets would recognize the added value, stock prices would respond favorably as well, and new equity offerings could be achieved at favorable valuations to repay the bonds or bridge loans.

But oil and gas prices began slipping in late 1997. By December 1998 the spot price had fallen to slightly above $10 a barrel, and over that time, the forward curve descended to approximately $15. Needless to say, the window to the equity markets closed for these E&P firms, and the loans became bridges to nowhere. An article we wrote for this magazine calculated that the year-end 1998 debt levels for a representative group of 20 E&Ps were 1.75 times the level of the SEC-10 value of their proved reserves. (See “Heavy Workout,” Oil and Gas Investor, December 1999.)

The years 1999 and 2000 turned out to be busy ones for workout specialists at banks and investment banks as well as for bankruptcy lawyers in Houston, Dallas and points east. About 10 E&P companies sought protection under Chapter 11.

Could some companies be on a similar path today?

The 1990s versus the 2000s

The experience of the past few years mirrors the late 1990s in striking fashion. After prices recovered from the 1998 collapse, they languished in the range of $20 to $30 per barrel for four years until early 2004, when increasing worldwide economic activity and constrained wellhead deliverability launched an inexorable climb to $100 and beyond.

The Cushing spot oil price passed $50 in October 2004. It then climbed to $60 in August 2005, $70 in April 2006, $90 in October 2007, and $100 by March 2008. It peaked at $145 four months later, in July 2008. The trend of the five-year strip was similar (see chart).

Needless to say, the profoundly more attractive oilfield economics from 2004 to mid-2008 resulted in a flood of private equity and debt to the oil and gas business. By the peak in early 2008, an estimated $30 billion in private equity and $50 billion in high-yield, institutional and bank debt had been invested in independent oil and gas producers.

But, the more recent business model varied somewhat from that of the late 1990s, with some companies now deciding to remain private. They could use the robust private-capital and A&D markets as a means to develop properties and monetize that wealth creation. The public-equity markets were found to be cumbersome and problematic, whereas properties or entire companies could be developed with private capital, and then buyers found in private transactions—at prices that always approximated the underlying value of the commodity.

Private equity and various forms of mezzanine and senior debt were used to build asset bases and, when the strategic plans had matured to the point where imbedded property values were realized, a private sale was the preferred route.

Second-lien notes

The rapid run-up in prices, particularly in the 2006-2008 period, also attracted myriad debt instruments offered by institutions and banks. One of the most actively employed instruments was a relatively new one, the second-lien senior note, provided by both banks and a variety of other institutions.

These notes were secured by second mortgages behind traditional senior bank facilities, with maturities slightly longer than the bank deals, and relatively liberal coverage tests for asset/debt and debt/EBITDA (earnings before interest, taxes and depreciation).

Second-lien notes were senior in the hierarchy of corporate debt, but still, they were junior to senior secured (mostly bank) debt, in terms of their rights to claim title to collateralized oil and gas properties.

Since the banks kept the price decks with which they determined borrowing-base availability at relatively low levels (approximately $65), providers of these new instruments calculated that the delta between these prices and the much higher forward curve provided an opportunity for an intermittent slice of debt capital just slightly junior to the banks.

Approximately $10 billion of these second-lien notes were issued in the period up to early 2008. Many were subsequently refinanced with high-yield issues with longer maturities and less restrictive covenants.

After prices peaked in mid-July 2008, the growing signs of an impending collapse in world economic activity resulted in the most dramatic collapse in oil and gas prices in modern history. From the high of $145 in mid-July, the Cushing, Oklahoma, spot price finally bottomed out during Christmas week at a level only a whisker above $30. After hitting a high of $143.74 on July 14, the five-year strip bottomed out at $54.81 on February 18, 2009 (see chart).

This also had a disastrous effect on the private-capital markets, as new-issue activity for debt and equity came to an abrupt halt by the end of third-quarter 2008.

Death spirals

Today, the leveraged oil and gas producer, which might have a suite of debt instruments from senior secured bank debt to second-lien notes to high-yield issuances to subordinated mezzanine financing, faces a situation very much akin to the producer of the late 1990s, i.e., a ratio of property value to debt of 0.9x. Table I lists the debt statistics of a representative group of leveraged producers, with a comparison of the PV-10 value of their proved reserves to total debt at December 31, 2008.

Where do we go from here? As the markets unfold in 2009 and 2010, the inability of many of these companies to service these debt structures seems clear.

Those E&Ps with traditional senior bank debt that borrowed significantly high percentages of their permitted borrowings under the usual debt structures will be faced with borrowing-base reductions as the banks recalculate their availability using much lower price decks.

Such companies will then face some sort of mandatory debt repayment. This will require operating cash flow to be used for such reductions, which will severely restrict the companies’ ability to continue the drilling necessary to maintain their asset bases.

Those with significant amounts of other debt—second lien, high yield or mezzanine—incurred to finance aggressive expansion of assets (that are now valued well below the valuations of mid-2008), will struggle to use reduced cash flows just to pay interest.

Unfortunately, this is the beginning of a death spiral. With no capacity to develop additional cash flow by developing properties further, they will be like their 1990s brethren, producing depleting assets just to pay interest. Their assets will deplete but their debt will not, a problem that will only get worse. The business model they pursued, developing properties toward an asset or company sale, is equally dead, with no buyers in sight at prices that will cover the debt.

Working out of this spiral would be difficult enough, but conditions today may make it unusually so. The larger problems in the worldwide credit markets have taken their toll on all types of institutions. Banks are constrained in terms of the relief that they can offer.

Much of the institutional debt is held by a relatively opaque group of investors that may be hard to find. Establishing reasonable negotiation may prove elusive. Many of these were hedge funds, some of which have ceased to exist, having drowned in a sea of debt of their own.

Final outcomes

Today the leveraged producer has a ratio of property value to debt of 0.9x. As the markets unfold in 2009 and 2010, many companies will find it difficult to service these debt structures.

Once a leveraged producer reaches the point where efforts to meet debt-payment obligations result in assets depleting in advance of the reduction in debt, or once a negotiating position with a group of creditors gets to the point where restructuring options are so limited as to preclude an acceptable outcome, then some hard decisions must be made.

In some instances, a bankruptcy filing will be necessary, to put the restructuring process into a legal forum, i.e., the bankruptcy court, where values can be reasonably apportioned among creditor groups and equity holders. To date, approximately 25 upstream companies have already filed for protection under Chapter 11 of the Bankruptcy Code, more than twice the number of the late 1990s.

In rare instances, similarly difficult restructurings may be accomplished without a bankruptcy filing, but in all eventualities the process must find a starting point, a point at which the bleeding—the depletion of assets with no change in debt levels—is stopped.

Then, all parties can begin to work towards a triage of the various levels of debt. This will be a tedious and time-consuming process, and some creditors will eventually look for whatever exits they can find at whatever prices are available.

In the final analysis, the magnitude of the distress in the industry today, as measured by the size of the debt positions and the ratio of debt to asset values, is quite large. Coming on top of the distress in the world economy, the opportunities for investment coming out of these conditions will be the best seen in our lifetimes.

The primary opportunity, at least initially, will be to purchase distressed debt positions from various holders; some of these will be available at small fractions of their par value and, most likely, at discounts to the real value of the underlying oil and gas assets.

This is because the absolute levels of distressed debt in this industry and the overall distress in the world credit markets will eventually cause many holders to sell at whatever values can be achieved in the secondary markets, where the only price setters will be investors for whom the idea of seriously distressed investing is a core business model.

In time, as the world economies recover and as oil and gas demand begins to rise again, with limited new deliverability from the wellhead, oil and gas prices and oilfield economics will also rise—and the value of owning interests in oil and gas properties gained through distressed investing will rise even more rapidly.

Bob Wagner and David Johnson are principals with Rivington Capital Advisors, a financial intermediary based in Denver and Houston.