Independents vulnerable to debt trap
A combination of aggressive cost-cutting and judicious hedging has given at least some independents a fighting chance of coming out the other side of the coronavirus crisis intact
Most recent coverage of the independent oil company sector has inevitably focused on how many companies will go under if oil prices do not rebound quickly. It is not hard to see why; the combined debt of independents listed in London as of 27 April, for example, was more than twice their total market capitalisation.
Hedging has bought some operators valuable time—a typical company is likely to have hedged as much as 50pc of its output for at least a year. But with the price of such insurance now prohibitive, efforts to contain debt have shifted firmly towards reducing costs in general and capex in particular.
“Many US-based independents have announced cuts of 40-50pc, which is quite a significant response to the current situation,” says David Round, E&P analyst at bank BMO Capital Markets. “Other companies that appear well placed from a debt perspective include Dallas-based independent explorer Kosmos Energy—which confirmed in April that it had voluntarily reduced its facility commitments from $1.6bn to $1.5bn—whereas the likes of UK independents Enquest and Premier Oil perhaps have further work to do.”
Cutting capex is a widespread trend and is the most obvious way of seeking to balance the books. For example, Jadestone Energy, an Asia Pacific-focused independent, confirmed on 22 April that it had opted to defer its Australia infill drilling campaign into next year. In March, the company announced plans to defer the Nam Du and U Minh development projects in Vietnam, which collectively represent a reduction of 80pc of the company’s originally planned spending for 2020.
Weight of debt
But whether capex cuts alone are enough is uncertain. A trawl of sector analyst reports throws up a number of names that are deemed to be in imminent danger from a debt perspective—including US firms Chesapeake Energy, California Resources, Denbury Resources, Ultra Petroleum and Oasis Petroleum. Even recently highly rated companies such as US independents Devon Energy, Hess and Continental Resources are seen as vulnerable, while Fitch Ratings significantly downgraded Houston-based explorer Occidental Petroleum last month.
Law firm Haynes and Boone has monitored North American oil producer bankruptcies since 2015; its latest oil patch bankruptcy monitor reports that aggregate E&P debt was around $130bn in the first quarter of 2020.
“There may be some difficult refinancing negotiations ahead, but I would expect most to survive” Flynn, Price Futures Group
Analysis from analytics and data organisation Bank of America Global Research of the oil companies it covers globally shows the average announced capex reduction this year is around 30pc, but it has seen examples among independents where expenditure has been reduced year-on-year by 50pc or even more.
“When a company like Total or Shell announces a capex reduction it does not necessarily translate into a cut in oil investment because they are involved in other segments of the energy market, but the trend we have identified is that most of the reductions are focused on oil activities specifically,” explains the bank’s European equity research team head for oil and gas, Christopher Kuplent. In addition to capex reductions and suspensions of stock buy-back programmes, Kuplent notes that there are plans for dividend cuts at the stretched end of the sector—particularly among E&P independents and oil services companies.
A wave of Chapter 11 bankruptcy announcements in the US suggests some independents thought about accessing the bond market but decided it was not the way to go. At the beginning of April, shale producer Whiting Petroleum filed for Chapter 11. Chesapeake and Oklahoma-based Chaparral Energy have been trying to restructure debt and it was reported in late April that offshore drilling contractor Diamond Offshore Drilling had also filed for bankruptcy.
In the E&P space, BofA Global Research sees the leverage ratios of more firms becoming unsustainable in a lower oil price environment. Due to this, banks are likely to look more favourably on companies seeking an alternative to bond issuance than ones looking to for new issues. Indeed, many E&P independents are already relying on reserve-based lending to a greater degree than the bond market—securitising loans from a syndicate of banks or facilities against an assessment of their underlying reserves.
Kuplent agrees that there are many negotiations ongoing as to whether these facilities need to be resized. “Any renegotiation will come with covenants and some of those covenants may be put ‘on holiday’ if lenders can see a path forward,” he explains. “At that stage, a return to the bond market would be based on the state of the bond market rather than a specific oil price.”
The only significant debt issuance by an independent that had been previously flagged and then cancelled among the companies covered by Round is Vancouver-headquartered explorer Africa Oil Corp. “This bond was designed to smooth out the payment mechanism on some of its other debt facilities,” he says. “I am not aware of any other independents planning to issue debt instruments.”
Stewart Williams, vice president of the institutional investor service at consultancy Wood Mackenzie, says independents can be expected to make defensive draws on their revolving credit facilities to preserve liquidity, especially those with maturities due in 2020 and 2021.
A major risk factor for the sector is the next round of semi-annual borrowing base redeterminations, which typically occur in April. Banks are expected to revise price decks significantly lower, which would negatively impact the available credit extended to borrowers.
Williams also observes that banks will want to manage their exposure without sending a large portion of the industry into default, raising the prospect of debt covenant violations. He expects several will be forced to restructure their debt, whether in or out of bankruptcy court.
$130bn Aggregate North American E&P debt
Phil Flynn, senior energy analyst at brokerage Price Futures Group and author of The Energy Report, says it is too early to say whether the steps taken by independent oil companies (such as reverse stock splits) will mitigate the impact of Covid-19 prevention measures and the price crash on debt levels. He agrees that negative prices have made it harder for independents to issue debt in the short term, but he is also confident that a combination of production cuts and the US topping up its strategic reserve will ensure prices do not return to negative territory.
“There is no specific price at which oil companies would feel confident about returning to debt markets,” says Flynn. “It is more about stability and prices staying at a certain level for a period of time. In the meantime, they could expect to have to pay a pretty high rate of interest on any new debt issuance.”
Unfortunately, for many independent companies there are no country-led backstops for money, which is one reason why we are seeing many oil companies under stress with rising debt-to-equity ratios. These companies’ debt issuance prospects will not be favourable, with credit likely to come under higher scrutiny amid a lack of oil storage, depressed imports/exports and—most of all— demand disappearance.
The harsh reality is that if oil prices remain south of $20/bl, no oil company will be well placed from a debt perspective. However, Round notes that independents have experienced difficult market conditions in the relatively recent past and suggests that many are in better shape than they were in 2014/15.
“There may be some difficult refinancing negotiations ahead, but I would expect most to survive,” he adds. “I think some of the negativity around independents is misplaced.”