The term “financial forensics” conjures images of accountant-CSIs rooting out fraud, scams and exotic criminal activities. But applying the same skills and investigative approaches to ordinary business operations and calculations of value may be the key to survival for many oil and gas companies, which face increasing financial pressure in the coming months and years.

The basic facts are straightforward. Oil prices and rig counts are down 60%. Revenues of upstream companies are plummeting between 60% and 70%. Only idealists expect something other than a very long-term recovery.

To survive until then, producers will need to make themselves attractive to the next round of investors, by proving that they can consistently produce positive cash flow in a tough environment that will extend for several years.

It means that after all cash needs, operating costs, overhead, taxes, capex and debt service are covered, there will be sufficient cash remaining for the investor to realize a rate of return commensurate with the risk it is taking. To achieve this level of performance demands a thorough understanding of what it takes to run the business as effectively as possible.

In this context, financial forensics involves analyzing data to provide a basis for forecasting business operations. It is a discipline that has developed over the past 40 years in response to the legal system’s needs for clear, convincing and accurate financial analysis. It is based on analyzing detailed underlying empirical data and not on rules of thumb or benchmarking comparisons. As a result, it provides much more accurate and defensible analyses and projections.

In the pursuit of fresh capital, whether from current investors or new ones, a company must be able to show that it can achieve “breakeven,” i.e., generate enough cash to meet all its demands for cash, and at various oil price levels, $30, $40 or $45/boe. A persuasive demonstration that this will occur requires creating detailed, dynamic models of the company’s operations, including modeling costs of production, overheads and capex requirements.

Start with revenue

The process starts with revenue projections, and three factors play into this: capacity, demand and commodity price. E&Ps are seeing the effects of reduced oil and gas demand and corresponding drops in the prices they receive. To be credible, revenue projections must be based on quantifiable evidence of the company’s capacity, such as existing well decline curves.

Current prices actually received by the company should be used for the base case, but alternative scenarios should also be built to demonstrate the effect of lower prices. The company should not assume prices and demand will return to a previous “normal” in a few months, or even a few years. The often-overlooked reality is that oil prices have never recovered to the level reached in 1980, while nominal oil prices took 23 years to recover to their 1980 level.

Then, costs

All costs, whether operating or overhead, should be classified as either avoidable or non-avoidable. Non-avoidable costs are those that will be incurred regardless of the level of drilling and production operations, such as management salaries. Avoidable costs are those that will be incurred only as a result of the business operation itself. For example, an overriding royalty interest is avoidable as it is only paid when a well actually produces.

A major objective is to determine how costs will change as production levels change. This can be a direct one-to-one relationship, such as percentage royalties, or a more complicated interaction.

The key is to determine, based on the company’s historical operating data, how these costs can be reduced both absolutely and per unit of production, and at what level of production the costs will increase stepwise (for example, an additional truck and driver are needed to handle the increased volume of production).

Over a given range of production, beyond the expense of finding and developing reserves, total costs will be a function of a cost per unit of effort, multiplied by those units of effort. Historical analysis of each of these components is necessary to determine not only the efficiency of the function, but also the unit cost associated with it, and whether the units are priced at current market levels or have become inflated over time.

Core vs. noncore assets

Finally, operational and cash-flow assessments must be performed to identify the essential, productive elements of the company’s business. Which assets are required to maintain a level of operations that can generate breakeven cash flow? Assets that are not required are noncore and should be sold to provide liquidity.

Managers must assess the oil and gas assets projected to generate positive future cash flow—such as drilling new wells or additional laterals needed for future production. These must be evaluated on the basis of not just their revenue potential, but also on the cost of the capital investment needed to produce that revenue. This is particularly critical in the shale plays where wells have a steep decline curve.

Capex requirements must be estimated based on the volume of work to be done, the cost of that work, and the minimum amount of work required over the next three to four years to maintain production levels—rather than the optimal amount of capex to grow production if there were no capital restraints.

Potential pathways

Although most E&P companies are upside down on their loan-to-value covenants, a variety of options are available to them. These choices all depend on clear-eyed financial forecasts that demonstrate the value of the company’s reserves and its viability at depressed oil prices over the next two to three years.

Alternatives can include one or more of the following options, all of which will require current lenders to take haircuts (discounts), and may require equity dilution in the company:

Non-bank bridge financing. For a company with traditional bank debt, bridge financing may be available from a non-bank lender with no or minimal equity dilution. The forensic projection must demonstrate sufficient cash flow to pay interest and maintain the required loan-to-value ratio, typically 75%-80%, as reserves are depleted.

Longer-term capital. For a company with significant potential in its proved undeveloped acreage, and which cannot demonstrate sufficient cash flow from existing production, some form of longer-term capital is required. Again, it is necessary to have solid forensic projections that reflect the real expected costs of developing the acreage to attract the needed combination of debt and equity.

Restructured debt. In some cases, where a company has non-bank debt, the best strategy will be to recognize the loss in value of the lender’s loan and reflect that in a new financing combining new, lower debt levels and equity.

Even if a company has to resort to the bankruptcy courts, the ability to stave off creditors and buy time will depend in large part on the company’s ability to present a solid, forensically sound analysis that clearly demonstrates that creditors are not losing value. The same sort of analysis will be needed to defend the company’s plan of reorganization in order to exit bankruptcy.

There is no crystal ball to help managements and boards through the excruciating decisions that are upon them, when the pressures of operational and strategic judgment calls are compounded by the demands and expectations of investors and creditors. Regardless of whether the ultimate decision-making venue is a boardroom negotiation, a private equity investor’s office, or a bankruptcy court, when that day comes, it will be insufficient to have relied on assumptions that are not quantifed, or on industry rules of thumb to support a decision that will shape a company’s future.

Hard data collected and analyzed by experienced forensic accountants will be invaluable to define an optimal strategy for recovery, to identify common ground among interested parties or, alternatively, to create the strongest available defense of your position.

Marc Schwartz is president and co-founder of the Houston-based business valuation and litigation consulting firm HSSK LLC, and a principal in the firm’s litigation and restructuring practices. David Butler is a manager in the firm’s valuation practice.