Fall 2015 Oil & Gas Capital Markets Outlook: There will be blood

Hanwen Chang, NEXEN, Houston

Punitive and catalytic fall redetermination cycle
With a particularly generous equity market and a fairly benign credit redetermination cycle, many E&P companies were bailed out by investors and banks in the first half of 2015. There has been over $23 billion of equity issued by US and Canadian publicly-listed E&P companies since the OPEC meeting at the end of November 2014, an estimated $20 billion of asset sales, and billions more of debt and private equity capital that has been injected into the system. However, as the over-supply situation continues with no signs of improvement in the short-term, and oil prices continuing to test lower territories, the second half of 2015 is expected to look very different. The upcoming fall borrowing base redeterminations could be punitive mostly driven by:

  1. Commodity Price Deck: Banks' long-term price decks could flip from a premium to a discount to strip given the duration of the downturn. The strip has also shifted downward compared to February when borrowing bases were determined.
  2. Hedges: revenue credit received for hedges will run out as E&P companies have little hedge protection in 2016 and thereafter.

Selected US E&Ps % of hedged oil production 2015 vs. 2016 (as of 2Q15)

Source: FactSet, Company data, Evercore ISI Research

Selected U.S. E&Ps % of Hedged Gas Production 2015 vs. 2016 (As of 2Q15)


Source: FactSet, Company data, Evercore ISI Research

However, there are some factors that may potentially offset lower price deck and diminishing hedges:

  1. Cost deflation: In the spring borrowing base redetermination cycle, banks did not give full credit to oilfield service cost reduction, as it was fairly “untested” at the time.  On its latest earnings call, the CFO of EP Energy, Dane E. Whitehead, mentioned that he believes banks will give full credit for any proven cost savings in the fall redetermination season.
  2. Reserve growth in 1H 2015: Although nearly all E&Ps have cut capex and activity levels, as 60-75% of the expected annual capex was spent during the first half of the year and service cost down 20-50%, many E&P companies still had achieved some reserve growth in 1H 2015.

Another important factor to be considered is how banks will respond to the additional regulatory pressure on reserve-based lending during this cyclical trough. The Office of the Comptroller of the Currency (OCC)’s National Risk Committee recently put the oil and gas lending near the top of the list as an industry which poses a threat to US banks, given the unpredictable swings in oil prices. The director of commercial credit for the OCC said in an interview, “We are beginning to see some deterioration in the credit quality of oil and gas loans to borrowers that used high volumes of debt to finance their growth over the past several years.”

Moreover, it's highly likely that the Fed will raise interest rates in 2015 or early 2016. Although the Fed has been very clear that the pace will be very slow, higher interest rates means even less capital flowing into oil and gas equity markets and more financial burden to companies.

Revolver drawdown: Upstream MLPs take the lead
Due to the wave of equity and debt financing in the first half of 2015, revolving credit facilities for large cap and mid cap E&Ps are relatively clean. Small cap E&Ps and upstream MLPs are most vulnerable to borrowing base reduction. On average, upstream MLPs remain about 60% drawn on credit facilities at the end of the second quarter of 2015.

US large cap E&P company revolving credit facility utilization % (as of August 25th, 2015)

Source: FactSet, Company disclosures

US Mid cap E&P company revolving credit facility utilization % (as of August 25th, 2015)

Source: FactSet, Company disclosures

US small cap E&P company revolving credit facility utilization % (as of August 25th, 2015)

Source: FactSet, Company disclosures

US Upstream MLP revolving credit facility utilization % (as of August 25th, 2015)

Source: FactSet, Company disclosures

Lower oil, more equity?
To pay off the cap between current and new borrowing base and fund 2016 drilling programs, companies are facing two options, selling assets or issuing equity. Since non-core or unproved assets do not contribute to the borrowing base and do not impact EBITDA much, it makes sense for operators to divest non-core or unproved acreage. Although there is a large amount of private equity capital waiting to be deployed, PE buyers appear to be looking for high quality assets. It is unlikely that non-core or unproved acreage will receive high bids from multiple players. Financing could also come in the form of Joint Ventures, Joint Developments, farm-outs, and outright working interest sales. But in many cases the most valuable assets are the higher quality producing properties, and divesting those impacts EBITDA, which in turn impacts leverage ratios. Therefore, issuing more equity seems like a logical option.

On Aug. 5th, RSP Permian announced an offering of $157.5 million equity and $200 million senior notes. One week later, Diamondback Energy announced an offering of $175 million equity. These two companies all issued equity in the spring. Notably, Diamondback Energy has tapped the capital market three times in 2015. This indicates that the capital markets are still open to high quality companies. Since companies access the capital markets when they are open, we will see some more equity issuance from high quality names in the next two months. However, public equity and debt financing windows seems largely closed to companies that have assets in marginal plays or acreage in marginal areas of core plays, which truly need an injection of capital.

Shrink to survive, hopefully...
Goodrich Petroleum recently announced the sale of its proved reserves and associated leasehold in the Eagle Ford for $118 million. The company will use the proceeds to pay down its revolver balance. Goodrich's $150 million revolver will be reduced for this sale along with lower marked to market value for remaining PDP's from Tuscaloosa Marine Shale and Haynesville Shale in its October redetermination. Goodrich is expected to not need any revolver liquidity until 2Q16, buying the company some time for a commodity turnaround. Penn Virginia announced in early August that it had retained Jefferies to "evaluate strategic alternatives" for its assets in the Eagle Ford. The news came just days after the company ruled out raising cash by issuing debt.

Most operators view selling core assets (especially proved reserves) as the last option to consider since they must forego all of the upside potential of such assets, including a recovery in commodity prices and future development. However, with capital-raising off the table, cost-cutting mostly done, and non-held by production (HBP) acreage drops in value every day due to lease expirations, companies have little recourse except to sell core assets, basically cutting themselves in order to live.

With the potential for Iranian barrels to pressure prices even further, recently there appears to be a greater consistency of expectations between buyers and sellers that prices would be lower for a longer time, which may help A&D deals get done. Thus, the borrowing base redeterminations in this fall will be the catalyst for A&D deal flow. More A&D activities are expected in the latter part of 2015, increasing in 2016.

Merger of equals and joint ventures
During the EnerCom Oil & Gas conference in August, the CEO of Approach Resources, J. Ross Craft, said that the company is searching for like-minded operators who may be interested in an all-stock merger, which would provide for synergies from potential SG&A reductions as well as efficiencies of scale on the combined entity. This indicates that, in the current environment, as companies focus on capital productivity/efficiency, there may be a rise in mergers of two roughly similar sized E&Ps, or zero premium M&A deals, as scale provides the opportunity to cut costs and boost efficiencies.

There may also be an increase in joint ventures, as it will become a preferred route of securing additional capital in a low price environment. Comparing to asset sales, the JV structure benefits the seller by allowing for increased production and cash flow while still retaining some upside from assets. The bid-ask spread is more manageable for JV structures as they can take various forms, which helps deals get done. Chesapeake Energy CEO Doug Lawler mentioned in the company's latest earning call that the company is currently reviewing opportunities in multiple operating areas to create additional value through strategic asset sales, joint venture agreements and participation, or farm-out agreements.

On August 25th, GEP Haynesville LLC announced a definitive agreement to acquire Haynesville Shale assets for $850 million from Encana Corporation. GEP Haynesville LLC is a joint venture of GeoSouthern Energy and GSO Capital Partners, a credit-focused investment group of Blackstone. This deal could be a model for upcoming joint venture deals between E&P companies and private equity companies. A few years ago, joint ventures were mostly funded by national oil companies and international majors, which were trying to enter into and gain knowledge about US shale plays. This time around, savvy private equity investors are most likely to be on the other side of the trade.

Alternative financers are picking up business
Some private equity firms provide lending at a higher cost of capital than a bank would charge with a similar focus on securing the loan with an asset. These firms tend to provide capital to smaller E&Ps and cede working interests to the operator until a certain return hurdle rate is met. This is basically equivalent to debt providers lowering effective rates or extending payback periods, similar to the covenant relaxation that many public companies receive. These higher-cost lenders have recently seen a pick-up in business. As a borrowing base reduction is expected in the fall and equity and debt financing window closed, more small E&P companies will be pushed to work with these lenders.

On July 6th, Legacy Reserves LP (LGCY), an upstream master limited partnership, announced an agreement with TPG Special Situations Partners (TSSP) to fund horizontal development of LGCY’s acreage in the Permian Basin. TSSP will fund 95% of the development expenses and receive an undivided 87.5% interest in LGCY's working interest in the acreage until a 1.0x ROI is achieved, then a 63% interest until a 15% IRR is achieved. TSSP has initially committed $150 million to fund the first tranche of the program, and has the right to participate in future opportunities (LGCY estimates $700 million of total opportunities).

On July 28th, Lonestar Resources announced a Joint Development Agreement with a private investment firm, IOG Capital. The latter will loan Lonestar up to $100 million for their Eagle Ford drilling program. Wells to be drilled need to meet return criteria of both IOG and Lonestar. IOG will contribute 90% of the up-front well cost. After a specified return is achieved, IOG's working interest will decrease to 10% from 90%.

Lonestar's CEO Frank D. Bracken III commented, "… this agreement will allow Lonestar to more aggressively pursue additional farm-in opportunities without materially augmenting our capital budget.  Farm-ins have been a principal source of leasehold and reserve growth for Lonestar in 2015, and we see that trend continuing."

On August 10th, Magnum Hunter Resources entered into a non-binding letter of intent with a private equity fund to develop unproved Utica and Marcellus acreage. The agreement covers a total of 28,500 net acres, but will initially target 9,500 net acres within the leasehold with the fund committing up to $430 million. The fund will own a 100% working interest in the farm-out until it achieves either a 12% IRR or 1.2 times multiple on invested capital. Once the hurdle rate is met, 90% of the working interest would revert back to Magnum Hunter.

These types of deals would become effective ways to grow reserves for companies having liquidity issues. On a large scale, it would also be an ideal fit for companies like Chesapeake Energy which owns a large inventory of unproved acreage with high potential in the emerging Meramec play (mostly HBP). These deals would increase reserves in non-core areas and borrowing base for an E&P without raising the capital budget. There will be many more similar deals going forward in a variety of structures.

The borrowing base redeterminations this fall will be the catalyst for M&A deal flow. More companies are expected to become distressed and more A&D activities are expected in the latter part of 2015, increasing in 2016. More small E&P companies will turn to private equity for financing deals. There may also be a rise in mergers of similar sized small E&Ps and Joint Ventures between E&Ps and private equity firms.

About the author
Hanwen Chang is a corporate development associate at Nexen. He holds a bachelor's degree from Northeastern University and a master's degree from Texas A&M University. Hanwen is a CFA charter holder and a member of the CFA Institute and CFA Society of Houston.

This article represents the views of the author. Any opinions expressed do not necessarily reflect the views of Nexen or any third party.


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