The Quest For Capital

In the energy sector’s quest for capital, options have narrowed considerably for upstream companies over the past year or so. As macro factors clouded the global energy outlook, the oil and gas industry fell deeply out of favor with investors by the end of the second quarter. Issuance of new equity by E&Ps came close to drying up, and overall costs of capital have risen markedly.

Mezzanine financing remains a reliable standby when broader capital markets doors are swinging shut. E&Ps also occasionally resort to convertible preferred issues, which combine a lower yield with the attraction of selling equity at a substantial premium to the prevailing common share price.

But necessity is the mother of invention, and creativity has bloomed in some corners of the financial sector. In addition to the above, relatively less well-known instruments are emerging. Some E&Ps, for example, have turned to “delayed draw term loans” to fill gaps left by the tighter regulatory environment in commercial bank lending. Oilfield service companies, in some cases fresh from bankruptcy proceedings, have had to seek financing for new equipment via capital leases.

How pressing has the search been for new financing?

To provide a sense of the downward spiral in sentiment for oil and gas, in early July, The Wall Street Journal ranked “first-half winners and losers” in terms of possible investment vehicles. The survey covered world stock markets, bond markets, commodities and currencies. Against a compilation of about 120 investment options, the negative returns of the S&P 500 Energy Index, as well as crude oil and natural gas, translated into a sub-100 ranking for all three investments.

This is a far cry from the tone of last year. In the second half of 2016, both SM Energy Co. and PDC Energy Inc. made substantial acquisitions in the Permian Basin, financed in large part via upsized equity offerings. Significantly, the E&Ps also launched five-year convertible senior note issues on highly attractive terms. The convertible notes carried coupons of just 1.5% and 1.125%, respectively, while conversion premiums were in both cases set at a generous 35% over the equity offering price.

Fast forward to June of this year, and a similar Permian purchase required a more complex—and costly—financing package. In addition to a substantial equity component, the buyer issued senior notes with a coupon of 8.25%, as well as redeemable preferred stock paying quarterly dividends at a rate of 8.875% per year. The preferred issue investor also garnered warrants to purchase common stock at an exercise price set at a low double-digit premium to the equity offering price.

In addition, terms called for the buyer to make contingent payments to the seller in the event West Texas Intermediate (WTI) oil averages over $50 in any one of a series of future years.

“As hopes of $60-plus WTI have evaporated, robust innovation is underway in the energy financing markets,” said Todd Dittmann, who leads the energy team for Angelo, Gordon & Co.

Financial creativity

So how are capital providers innovating to meet E&Ps’ needs?

“As hopes of $60-plus WTI have evaporated, robust innovation is underway in the energy financing markets,” said Todd Dittmann, who leads the energy team for Angelo, Gordon & Co. out of Houston. “The withdrawal of traditional sources, such as commercial banks, appears to be a longer-term secular trend. For regulatory and internal risk management reasons, the banks have limited appetite for anything much beyond large acquisitions in the Permian and Scoop/Stack plays, and only for clean balance sheets.”

Dittmann describes Angelo, Gordon’s energy practice as focused on “debt structures that offer growth financing and more patience than commercial banks’ twice yearly redetermination of availability.” As an example, earlier this year, Angelo, Gordon led the $300-million first lien, delayed draw term loan for independent Rex Energy Corp.

“This was a non-bank answer to the revolver,” said Dittmann. “A piece of the term loan is funded upfront, and there’s a remaining piece that the client can then borrow over time—but only once; it doesn’t revolve. It’s a cost-efficient way of accessing additional capital that the borrower does not have to borrow all at once.”

The Rex Energy delayed draw term loan matures in April 2021 and bears interest of LIBOR plus 8.75%. Initial borrowings of approximately $144 million were used to repay all outstanding loans and obligations under the company’s previous senior secured credit facility and fees and expenses associated with the term loan. Additionally, the financing placed about $19.3 million of cash on the balance sheet, according to Rex Energy.

Following repayment of the senior secured credit facility, Rex Energy had roughly $111 million of additional capacity under the term loan. This was earmarked for developing the company’s core assets in the Pennsylvania Marcellus and Ohio Utica shales. Under certain circumstances, the E&P noted, the term loan permits the issuance of up to an additional $100 million in secured first lien debt for further reserve development and acquisitions, “positioning Rex Energy well for years to come.”

Rex Energy CEO Tom Stabley said in a statement that the new financing tool would “further ensure the execution of our two-year development plan in the Appalachian Basin. The term loan provides Rex Energy with additional liquidity to continue to develop our high-return locations and the potential to access the M&A market.”

In addition, the loan included some $46.5 million for outstanding undrawn letters of credit (LOC), making the new facility “a true bank replacement,” Dittmann said.

Also in the Appalachian Basin, Angelo, Gordon recently funded Diversified Gas & Oil Plc’s purchase of certain assets from Titan Energy LLC. The deal called for cash consideration of $84.2 million, which the E&P funded by an equity raise of $30 million coupled with a three-year, $110-million senior secured credit facility with a “high single-digit interest rate,” according to Diversified.

The initial draw was $75 million. The overall facility will furnish liquidity needed to close the acquisition, supply additional working capital and provide “delayed draw liquidity for future development and acquisitions,” said Diversified CEO Rusty Hutson.

‘One-and-a-half lien’

A further twist—“lien sharing”—has emerged from what was once the sole province of commercial banks. It allows non-bank lenders to share in the banks’ first lien. This is termed by some a “one-and-a-half lien,” according to Dittmann. “In their desire to be repaid, the banks have set a precedent for non-bank lenders to share in first liens, but on a second-out basis,” he said.

Dittmann pointed to three recent lending agreements, including one with California Resources Corp., where a commercial bank group reduced exposure by permitting non-bank lenders to participate in a one-and-a-half lien. In the “fairly doctrinaire” banking sector, the new format broke prior norms.

“Previously, it would be a rare event to find a bank willing to share their first lien with you. As a result, there are pricing benefits to the borrowers.”

Angelo, Gordon has also worked with clients in the oilfield sector. Notably, as an anchor investor, it was recently instrumental in structuring a $600-million, 144A, senior bond issue for Transocean Ltd. The offshore driller’s bond was secured by the recently delivered Deepwater Thalassa rig, which has a 10-year contract to work for Royal Dutch Shell Plc.

Deal placement was aided by structuring it as a “144A for life” issue, which enables aftermarket trading.

“We worked with Piper Jaffray [Cos.] to structure and syndicate a more liquid financing instrument that, in aftermarket trading, would better reflect the underlying risk of Shell than a long-dated buy-and-hold loan,” recalled Dittmann. “The notes we structured ended up being a better instrument than an illiquid loan for both borrower and note purchasers. The liquidity attracted a much bigger buying universe.”

The bond carried a 7.75% coupon and was issued at an original issue discount of 3%. Soon after, Transocean issued a second $600-million bond employing a substantially similar structure, carrying a 6.25% coupon and an original issue discount of 1.5%.

Reports from the broader oilfield service sector point to some smaller players having to rely on capital leases to finance new equipment—even after coming out of bankruptcy and being recapitalized. For example, Basic Energy Services Inc.’s first-quarter report outlined plans for 2017 capex to be set at $115 million, with “capital leases and other financings” comprising $70 million.

“You’re starting to see a return of growth and a need for working capital in the oilfield service sector,” observed Dittmann. “Even more senior secured capital has been withdrawn from the oilfield sector than from E&Ps. The need is great.”

Convertible preferreds

Smaller E&P players, such as Fort Worth, Texas-based Lonestar Resources US Inc., also have tapped the convertible preferred market to finance acquisitions. And in the case of Lonestar, which had a market cap of around $96 million in late May, the acquisitions’ relative size was notable: $116.6 million, including $105 million in cash, for two simultaneous purchases of Eagle Ford assets.

At $80 million, the largest portion of the financing came from a convertible preferred stock issue negotiated with Houston-based Chambers Energy Capital. The dividend on the preferred issue offers a 9% yield (slightly higher if factoring in an original issue discount of 2.25%). Dividends, normally paid in cash, have a payment-in-kind (PIK) provision at Lonestar’s option for up to 12 quarters. The preferred stock is convertible into common at $6 per share, a 45% premium over the recent common stock price.

“The market for new issuance of equity and debt in the public markets is pretty strained right now,” observed Chambers partner Phil Pace after the Lonestar deal was announced. “The equity and the high-yield markets are not particularly receptive. Management at Lonestar needed to find alternative sources of capital.”

While Chambers has made some straight equity investments, it describes itself as an income-oriented fund, with investments focused on preferred paper and a wide range of debt structures, including first and second liens and unsecured debt. Investments typically range from $50- to $150 million, but have been as low as $30 million and as high as $225 million. “We cast a wider net than some, covering not just E&P but also oilfield service and refining and marketing,” said Pace.

Confidence in management’s ability to perform was not an issue, as the Chambers principals had a 30-plus-year relationship with Lonestar chairman John Pinkerton and CEO Frank Bracken. “It was a comfortable transaction to propose and to execute,” said Pace. But that is not to play down the severity of energy sector market conditions at the time.

“It was a pretty grim market,” Pace recalled. “But it was the right financing for the company, and we stuck to terms that were good for Lonestar on a transaction that is pretty transformative. We think it will work out really well for all the constituents: the common holders, bondholder and ourselves. We like how they’re executing.”

“The market for new issuance of equity and debt in the public markets is pretty strained right now,” said Phil Pace, partner, Chambers Energy Capital.

The relatively generous conversion premium—up 45%, at $6 per share—reflects in part the volatility inherent in small-cap stocks such as Lonestar, said Pace. Relative to the E&P’s prior-day closing price, the stock had intra-day moves of both down 6% and up 15% before closing at $4.40 per share. “We pay attention to the volatility and what that implies for the valuation of that conversion feature,” he noted.

The conversion price of $6 was set at a 45% premium over the 20-day volume-weighted average trading price through May 24. Notably, the conversion price worked out to be more than the price paid by investors in the common stock offering, at $5.75 per share, late last year.

“In a volatile sector, the terms always evolve over a three- or four-week process,” said Pace. “At the end of the day, it was pricing that we were comfortable with and, importantly, that would be well-received by other constituents in the capital structure and would position the company to take the next steps forward. We want Lonestar to be strong and healthy and growing.”

Chambers currently has one seat on Lonestar’s board, occupied by Pace, and it has been nominated for a second seat, subject to shareholder approval. “We want to be part of the strategic thought process going forward. By no means do we need to control it,” he commented. “We want to be in a position to be helpful, where we’re not just an investor, but have some oversight.”

Mezzanine financing

From an operational viewpoint, Lonestar has shown significant productivity gains on its Eagle Ford acreage, which is almost 60% larger following the two acquisitions. For example, in Brazos County, Texas, Lonestar’s B #1H well established a 30-day production rate of 2,123 barrels of oil equivalent per day (boe/d) over a perforated interval of 8,166 feet using a total of 16.6 million pounds of proppant. Lonestar has a 50% working interest in the Wildcat area, which holds 46 drilling locations.

“One of the things we like about the team is that they’ve done detailed analysis on what the best completion and production practices are, which you saw with the recent, very good Brazos well,” noted Pace. “In addition, they’ve analyzed which of the offset wells are most indicative of what to expect going forward with current proppant concentrations and fluid rates.

“The other avenue is that I think there will continue to be consolidation opportunities along this trend, which runs for hundreds of miles,” he continued. “Taking advantage of cycles—for example, everybody rushing to the Permian—maybe there will be some opportunities to get some value-added acquisitions done and build the company using a two-pronged approach of drilling and acquisitions.”

Mezzanine finance tends to find favor when major financial instruments in the capital markets toolbox are slumping, according to David Albert, managing director and co-head, Carlyle Energy Mezzanine Opportunities Fund II LP.

The $2.8-billion fund invests across several energy sectors, with a primary focus on the upstream sector.

“There’s definitely more deal volume when the capital markets are challenged than when they are robust,” said Albert. “While many of the businesses in which we invest do not enjoy access to capital markets on a regular basis due to their size or stage of development, activity always picks up for us whenever the capital markets are relatively closed.”

While mezzanine fund capital industrywide is not inexpensive, typically targeting double-digit rates of return, Albert said a key advantage is that it helps companies avoid permanent equity dilution. “If people have specific projects that are fixed in scope and scale, our capital may be appropriate because, even if it’s relatively high cost, it’s typically shorter duration. Project owners usually take us out after two to three years,” he said.

“It’s one thing to use third-party capital for a specific purpose and within a specific time frame. It’s another to permanently dilute your existing equity owners.”

Mezzanine finance also avoids the issues of control and governance typical of private equity, Albert noted.

Recently, Carlyle Energy Mezzanine Fund and EOG Resources Inc. struck a joint-venture (JV) drilling agreement covering the development of EOG assets in the Marmaton play of Ellis County, Okla. The agreement provides $400 million in funding for a four-year development program. After certain performance hurdles are achieved, Carlyle’s working interest in the program will largely revert to EOG.

While EOG has an investment-grade rating, providing it with easier access to capital, it also has a high-quality problem: years, or even decades, of drilling inventory. As a result, not all acreage that can generate attractive rates of return is necessarily able to compete for capital in a finite company budget.

For companies with decades of drilling inventory, the answer is not to wait, but to raise capital to accelerate development of the assets and bring forward their value, according to Albert.

“Even if a company needs to use more expensive capital in a drilling joint venture, you’d rather develop the assets today so you can get some near-term added margin and earnings accretion,” he said. “Another benefit of our capital is that it can be structured as a nonrecourse drilling joint venture, and thereby, it often obtains more equity-like treatment.”

As with drilling JVs in general, projected returns depend on the risk level of the assets and consistency of operations, Albert observed. “The greater the current production in a field—that is, the greater the number of analog wells with good well control—the less de-risking needs to take place over time, and often the lower the cost of capital. We do a lot of independent work to assess the risk profile of different opportunities.”

Albert noted that Carlyle’s team of 22 investment professionals includes three petroleum engineers. While the Permian captures most of the headlines, in part due to the ability to scale operations in the basin, he added, the Marmaton offers “high-quality rock and attractive returns, even in the lower current price environment.”

Elsewhere, the firm’s U.S. buyout fund, Carlyle Partners VI, agreed to help WildHorse Resource Development Corp. finance an acquisition of Eagle Ford assets through the purchase of $435 million of Series A, perpetual convertible preferred stock. Terms include a dividend rate of 6% per year and a conversion premium of 20%, translating into a conversion price of $13.90 per share. The company’s intention is “to pay dividends in preferred stock for the foreseeable future,” i.e., using a PIK option, according to WildHorse Resource Development.