Financing in the Age of Low Oil Prices
May 14, 2016
Relatively low oil prices are here for a while longer and at these levels, more oil and gas companies will struggle to service their debts. Interesting deals will come to the table, but investors must gain a better understanding of petroleum industry fundamentals.
The inability of major oil producers to agree on a production freeze in Doha last month implies that in the near term, oil prices will probably linger below the $50 per barrel. It also indicates that the oil price now has a new floor.
This could point to an emerging financial crisis in the manner of the crash of 2008. As homeowners defaulted on their mortgages, we may see oil companies default on loans. And like in 2008, a crisis could snowball to impact the global economy. But this scenario is unlikely. Prior to the last crisis, there was an unchecked distribution of cheap credit to homeowners, but in the case of oil companies, banks have done more due diligence.
Whatever the case, it seems like we are in for a bumpy ride and, in the end, everyone will come out a bit shaken. Bankers and hedge fund managers may find opportunities in this season of low oil prices, but we will also witness plenty of distress cases due to over-leveraged situations, bankruptcies, and potentially defaults. Investors will have to adjust their approach to assessing companies and assets.
Exploring new options
Most oil companies have tapped into capital markets to raise the requisite funds to produce oil. This has been done in many forms – shareholders’ funds, debt and bonds from the traditional purveyors of capital such as banks and hedge funds. Following the 2008 crisis, a lot of financial sector reforms were enacted, influenced strongly by the US Congress. The reforms have helped: Banks have been forced to maintain bigger capital cushions today than in the run-up to 2008, and even if the worst happens, it still doesn’t look like the effects of the oil price plunge could come anywhere close to eating through those cushions. This means we won’t be seeing a repeat of the financial crisis in the oil industry. However, at current levels, funding for ongoing operations, refinancing or even new investments will be challenging.
With the steep decline of oil prices, many companies’ cash flows have dropped and the values of their assets have fallen. Meanwhile the debt loads have not changed at all. Against this background, most companies will have to explore new options. Those with weaker balance sheets will have to consider auctioning off once-profitable operations that are no longer profitable, downsizing exploration initiatives, and finding alternative sources of funding. Some, like Petroceltic International, a London-listed explorer whose shares dropped 77 percent last year, will consider an outright sale of the business.
America’s petroleum sector is feeling the fallout. The Federal Reserve Bank of Dallas counted nine bankruptcy filings by US oil and gas companies, accounting for more than $2 billion in debt, in the last quarter of 2015. That’s a level not reached since the Great Depression.
Understandably, most investors today are wary of potential defaults in the high-yield market due to over-lending to the energy sector, and some are indiscriminately selling off “junk bonds”. Also contributing to the paranoia, Wall Street banks hold close to $3.9 trillion of commodities contracts, the bulk of which are based on oil and were written when it looked like the price per barrel would remain above $80.
Assuming the price stays below this point for the short to medium term, some of America’s biggest financial institutions may encounter challenges going forward. Public capital markets and large oil companies might pull back because of the resultant volatility, which would just increase the need for private investment. This uncertainty will no doubt continue to create potential for mergers and acquisitions of distressed and stressed companies or those companies entering the sector at lower valuations. However, the differences in price expectation between sellers and buyers will make it difficult to consummate most transactions at current levels.
“This uncertainty will no doubt continue to create potential for mergers and acquisitions of distressed and stressed companies or those companies entering the sector at lower valuations.”
Against this background, investors will need to understand pricing dynamics. Not every barrel has the same operating expense attached to it. It will be crucial to focus on assets with low operating costs and long reserve lives that can survive these downturns. Investors may want to focus on different sectors of the oil and gas business – upstream, midstream or services. Private equity businesses have tended to invest in late stage development or production. Perhaps now is the time to rejig the investment model and look at options that could enter production when the prices come back up.
Given the “new normal” in the global oil market, investors will have to refine their strategic planning and due diligence processes for potential opportunities. Private equity type acquirers will need to be savvy about oil and gas targets, as well as strategic in determining the quality and location of a target’s assets, the caliber of its management team and the cost and operational synergies it brings to the deal.