In late April, the IPAA held a conference focused on the large amount of debt and issues surrounding it that have led many oil and gas companies into financial trouble during this commodity price downturn. The last panel was a roundtable discussion exploring how the experience of past downturns can inform business strategies today.

Buddy Clark, head of Houston law firm Haynes and Boone LLP’s energy practice, which is engaged in and tracks industry bankruptcies, led the discussion. Other panelists included Bert Conly, senior managing director for FTI Consulting Inc., a firm that is active in oil and gas restructurings and reorganizations; Jim McBride, managing director with financial consulting firm Opportune LLP and formerly an energy lender with Capital One; and Jim Trimble, who retired as CEO of PDC Energy Inc. after serving as the company’s president following the 2008-2009 downturn.

Here are highlights of their discussion.

Left to right, Haynes and Boone’s Buddy Clark, FTI Consulting’s Bert Conly, PDC Energy’s former CEO Jim Trimble, and Opportune’s Jim McBride discuss best practices for avoiding and surviving a downturn.

Clark In prior downturns, did companies see it coming, or did it hit them in the forehead?

Trimble From the producers’ side, we never see it coming. We’re always optimistic, always looking for the opportunity. Every year when we run budgets, we look at the upsides and downsides, but no one ever believes the downside case.

Conly Somebody must have seen it coming or thought it could come, because of the tremendous hedge positions that some companies had before 2015 and ’16. We’re working on a couple of situations where companies have more than 80% of their production hedged for the entire year at pretty good prices. Either the lender is requiring it through the credit agreement arrangements, or they wanted to make sure they had the downside protection for cash flow and debt servicing.

Clark Why in 2009 and ’10, which was such a quick downturn, were there so many energy bankruptcies?

Conly I’m not sure companies were as hedged then as they are now. It’s one of the lessons people did learn. But the industry recovered, and we were in the mid-$60s by the end of the year. It was a different situation than where we are today. You had a lot of bankruptcies just because of liquidity problems.

Trimble In 2009, you didn’t have many shale plays that were known; they were just developing. You had a lot of people spending a lot of money getting into plays. Primarily all the production was coming from vertical wells, which aren’t as prolific as these horizontal wells have been.

McBride This cycle feels much worse to me than cycles did in the ’80s, and it’s because, on a percentage basis, commodity prices have fallen a lot harder, capital structures are a lot more complex than they were then, and the structure of the debt makes it more challenging to deal with.

The cycle we’re in now is the industry being a victim of its own success. The reason prices are so low today is because of the growth of U.S. production. Without the growth in U.S production, prices would be a lot higher today than they are.

Even though oil was at $100, most banks in 2014 were using a lending deck of $70, and then they were running sensitivities 20% below that, at $56/bbl. I don’t think most bankers foresaw the potential for prices to be below $50/bbl.

Clark What should the manager of a company do to protect for the downside?

Trimble Companies are always preparing for it; they just have a hard time believing it’s going to happen. But the upside could be just as bad as the downside.

One day production is going to be declining and cross that line with demand, and companies are going to be sitting there saying we’ve got to start moving up. Putting rigs and frack crews back to work is going to be as hard as ever, because we’ve laid off so many people in the industry over the last six months.

A lot of the young people are going back to school and getting MBAs. They have families to take care of and don’t want to rely on this cyclic industry.

Clark What happens if the Fed increases the discount rate?

McBride If you run sensitivities to cash flows, they’re much more sensitive to movements in commodity prices than to debt service on interest rates, but it’s going to have a negative impact on cost of capital.

First of all, capital is going to cost more anyway coming out of this cycle. There are not nearly as many banks that are going to be aggressively lending into the sector, at least for a brief period of time. The appetite has dried up quite a bit, and the only way to beef up that appetite is to make returns more attractive by offering higher rates.

Conly We’re seeing reserve-based loans [RBLs] be re-priced in the restructuring process, so a quarter to half point in the discount rate isn’t going to make an immediate difference, because the banks are already repricing things as they’re restructuring and getting prepared for the longer period. Even conforming RBLs are being re-priced in the restructuring process.

Clark Following this downturn, will banks approach the RBL business from a different perspective?

McBride Banks are just like any other business; they have to grow. They’re going to get through this cycle and learn lessons. For the near term, banks are going to be more conservative in lending to E&P companies. There are a number of different ways to get to loan value, but they all triangulate on the same number, and each bank has its own method.

But banks used to have a nonconforming tranche that’s gone now, at least for the near term.

Trimble In this period, the banks were pretty solid. They didn’t loan money recklessly. The companies borrowed money recklessly by going to high yield, to tranches and second liens. They borrowed money other than through the banks. The lesson learned is that companies have to look at their balance sheets and know that this debt is not free.

Clark Did the new shale play change the paradigm that RBLs were made against proved producing cash flow? With the shales, in the early party of the last boom cycle you didn’t have much production there. This required a producer that wanted to expand its business to find capital from somewhere else, and they looked to the public or second-lien markets.

The other phenomenon I noticed as an energy finance attorney was the private equity-backed teams, particularly from the very large private equity firms, were receiving incredibly good covenant packages and opportunities. Bankers always expected the private equity guys would back their management teams and not let the banks lose money, but that has turned out to be different. Will banks learn any lessons in that regard?

Conly Competition for business drives that. To an extent, that expectation is reasonable until the hole gets so big you just can’t fill it.

There’s a deal out there now where the hole is $6 billion to $7 billion. That’s just a big number for anybody to step up to. If it’s $200 million, and there’s a way to restructure a company around that, that’s one thing. But at some point the hole is too big for anyone to fill.

Clark The oil and gas industry used to have a lot of 363 asset sales in a bankruptcy, but now a lot of these companies seem to be going through a reorganization and exchanging all the debt for equity. Is that the new normal going forward?

Conly It depends on the asset base and the circumstances with the company. Some companies wait too long to get into bankruptcy and don’t have the liquidity, and the creditors force them into a sale transaction.

The other difference is the complexity of the capital structures. The holders of that debt want to take advantage of what everybody believes will be a future recovery in price, and they want to be there to get some of their money back. That is driving the restructuring of converting debt to equity as opposed to pushing things to a sale.

And they just don’t like the numbers they’re seeing from sales transactions. If I’m only going to get “X,” we’ll figure a way to fund this company and see if we can get some money back later, rather than take the beating now.

Clark Management teams feel they can make the decision to go into bankruptcy, control the bankruptcy and control the exit, but in fact the process can take over the lives of management teams and their boards of directors. How do you see the interplay between the boards of directors vs. the management team vs. all the consultants that come along with the baggage?

Trimble It’s critical for the management team and the board to be on the same page. If you’re in a restructuring situation, it doesn’t always mean you have to go to bankruptcy. There are other options.

If you’re going to go through bankruptcy, it’s very important that the board, management team and advisors have a clear understanding of what will take place, because if it’s not a pre-packed [prepackaged bankruptcy] and already known what’s getting ready to happen [per the pre-arrangement deal], it can quickly get out of your hands.

Conly Another reason we’re seeing companies having to go through a bankruptcy is because of the capital structures where there are indentures, and you can’t get the votes you need on a widely held issue outside of a bankruptcy.

You can get a controlling interest perhaps to support a restructuring plan or pre-arranged plan, but then you have to push it through a bankruptcy to accomplish the voting requirements, because they’re lowered typically in a bankruptcy—51% in number and to two-thirds in amount as opposed to 90% to 95% outside of bankruptcy. Because of that, we’ll see more prepackaged, pre-arranged bankruptcies.

Clark We’re seeing a lot of the bankruptcies more of the restructuring nature, where they’re converting a substantial portion of the second-lien debt to equity and keeping the reserve-based loan in place. But if prices don’t recover, do you expect to see some of these companies visiting the bankruptcy courts again for a “Chapter 22?”

Conly I hope not, but it depends on what happens with prices and how they manage the business. If they’re not in a position from a capital perspective to economically keep their reserves at least flat, then they’re going to be declining in reserve base, which means they’re going to be bumping up against the RBL limit, which will trigger requirements for pay downs. That’s going to be a wait-and-see.

The recommendation we’re giving to our clients now is that you want to build the restructured balance sheet around the cash flows of the business, as opposed to around the asset bases. In the oil and gas space, we know the need for capital is very intense all the time. And while the RBL borrowing-base calculation says you can put this amount of debt on it, when you look at the cash needs of capital expenditures as well as supporting the capital structure of the business, what do you really have from a cash-flow perspective?

In the old days, we put as much debt on it as we could to maintain that debt claim coming out of bankruptcy in case it got into trouble. People are learning the lesson that that’s not the best structure in this environment. That hopefully will help eliminate the Chapter 22 idea.

Clark What about a mezzanine deal where there is an equity kicker with an override? Do you see that as being problematic in a restructuring?

Conly You’ve just given away part of your value as part of the transaction. That’s a cost of the deal. So your net revenue interest is just lower for generating cash flow and availability to support your capital plan.

From the standpoint of what you have to work with to restructure a company, you want as much cash flow as you can get. I’d rather not have any of those burdens.

Clark This time around, I haven’t heard of any commercial banks threatening foreclosure. Do you think they’re trying to play the cycle through?

McBride Banks can’t be afraid of bankruptcy. Nobody wants to go through it, but if you act like you’re afraid of a bankruptcy, you’re not in a good negotiating position. You’ve got to be willing to deal with the assets.

There are a number of ways to maximize the value if you ultimately had to foreclose on the assets. You can convey it to another company, or you can bring in an operator.

But the most important thing for a banker to be able to do, if the borrower threatens to throw in the keys, is to be willing to say, “If you put them out there, we’re going to take them, and we’ll figure out a way to deal with it.”

Clark Service companies have reduced staff more than oil companies. Do you think oil companies have a lot more rightsizing to do?

Trimble We’ve seen that a lot of oil and gas companies postponed laying off in 2015, anticipating this could be a short-lived downturn, and they entered 2016 with staff levels that can’t be supported by the new, reduced capital programs. So we’re seeing companies now downsizing. And this downsizing, although painful, will continue through the remainder of 2016.

But companies have to be careful how much they do cut, because it’s going to be difficult when they start looking for the engineers, geologists and operating people. It’s going to be hard to find those guys willing to come back.

Conly With these prices, the G&A component of EBITDA has become such a big percentage relative to where it’s been. It has come under scrutiny: Lenders are looking at it, and people who are becoming equity [via debt for equity exchanges] are looking at it. It’s a tough situation.

They’re just going to lose good people necessary to support the company, and you might never get them back.

Clark Aren’t there distressed sellers out there now that have to sell assets?

Trimble Not yet. The banks have not been putting a lot of pressure on them. Everyone is looking now; they’re just finding it difficult to find quality assets. A lot of the bondholders don’t want to end up owning assets. Everyone is trying to work through it and is looking for a salvation.