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Wrong way on Wall Street

Lack of access to capital markets could have consequences for US oil production

Wall Street is like a window: sometimes open, sometimes closed. For US-listed E&P companies, if it is open at all, it is a sliver at best.

Sharply reduced access to stock and bond deals equates to less cash to grow oil output beyond projects already underway. It also alters the competitive landscape. IOCs like ExxonMobil and Chevron that do not rely on raising money in public markets could increase their share of production at the expense of small- and mid-sized E&P independents that do.

According to data from Dealogic, a company that compiles transaction statistics, US E&P companies raised only $3bn from equity sales last year, down 59pc from 2017 and 91pc from 2016. In the fourth quarter of 2018, when crude prices fell, just $157mn was raised, the lowest quarterly tally in a decade.

Almost all 2018 proceeds came via follow-on offerings by already listed companies; there was only one E&P initial public offering (IPO) by a newcomer. IPOs are not being pursued because shares of many already listed companies are trading below net asset value (NAV-the value of reserves and other assets, minus liabilities). Sponsors would have to price IPO shares at a similar discount to NAV, which would prohibitively dilute their own stakes.

"In my opinion, the reason you are not seeing any equity issuances is that investors have other places to spend their money," says Christopher George, director of capital markets at DI Capitalize, a platform owned by Texas-headquartered Drillinginfo.

Capitalize DI reports that the market capitalisation of energy-sector companies represented 5.6pc of the S&P 500 index's total capitalisation in February, down from 12pc in 2010, 16.4pc in 1990 and 28.2pc in 1980. Today's S&P index is dominated by technology companies. "Investors' attention is on other names in other sectors," George tells Petroleum Economist. "Now that the energy sector is only 5pc of the S&P, there is no reason investors have to hold a position at all."

The investors who have stayed in their E&P stocks are more demanding than they used to be, further reducing cash available to fund production growth. On their most recent quarterly conference calls, executives highlighted the change in investor attitude and how they are responding.

Disciplined capital investment

"There has been a recent shift in how capital providers demand that E&P companies generate returns," says Carl Giesler, CEO of US Mid-Continent producer Jones Energy. "Cash profitability, return on capital deployed, and free cashflow generation rather than production growth with prospective drilling inventory delineation is how E&P companies will be judged going forward. The market today is demanding that returns need to be driven through ongoing operations and disciplined capital investment on new projects and production, as opposed to flipping acreage or incorporating inventory growth into investor-relations presentations."

"Competition for investor dollars is more intense than it's ever been," says Richard Muncrief, CEO of Tulsa, Oklahoma-headquarter producer WPX Energy. "There will be some winners, but only ones who are laser-focused on returning capital to shareholders in one form, fashion or another and still show some degree of growth."

Publicly traded E&P CEOs repeatedly emphasise "financial discipline" and "investor-friendly" uses of cash, i.e. paying out dividends, paying down debt, and repurchasing shares-practices that effectively reduce cash available for capex.

"The onus is upon the oil and gas sector to not grow for the sake of growing, but to grow in a manageable way. If I put up a bunch of barrels with thin margins, all I am doing is destroying value," says George. "Investors are now forcing people to grow within their cashflows. Once companies start actually producing cash that can be sent back to shareholders consistently, and once they can do that as a sector, then investors will come back."

“Competition for investor dollars is more intense than it's ever been,” Muncrief, WPX Energy

James West, an analyst at investment bank Evercore ISI, explains in his 2019 outlook: "The emphasis on spending within cashflow is a direct response to investor backlash." He notes that in previous years, equity investors drawn to "the allure of growth" were responsible for "steady capital inflows to underwrite marginal barrels", allowing E&P companies to outspend cashflows by up to 20pc or more. Now that this investor behaviour has changed, he sees cashflow and capex moving in tandem.

Credit ratings agency S&P Global makes a similar argument, predicting "limited" E&P capital spending growth in 2019, in part because "US companies are sensitive to investor aversion to outspending cashflow".

Bonds decline

Meanwhile, the slump in equity sales is being mirrored on the bond side of the equation. Bonds are traditionally a much larger source of funding for E&P companies than equity, accounting for around twice the average annual proceeds in 2005-18.

According to Dealogic data, US E&P companies raised $19.8bn in the bond market last year, down 28pc from 2017 and the lowest annual sum since 2008. In the final quarter of 2018, just $1.5bn was raised, the third-lowest quarterly total in the past decade.

The interest rate charged for bonds is increasing, according to DI Capitalize, which also foresees an escalation in bond maturities ahead. This implies that more issuers may have to pay more for their new bonds when they refinance existing issuances. "There is a healthy amount of debt coming due in the next few years and, if I was anticipating a bearish interest rate move, I would try to refinance earlier," says George.

“Investors are now forcing people to grow within their cashflows” – George, DI Capitalize

The combined value of equity and debt proceeds for US E&P companies was $22.8bn last year, down by 35pc from the previous year and the lowest total since 2007, according to Dealogic data. But there is a bright spot for US-listed E&P companies in terms of capital access: bank debt. Higher access to bank debt has been used to counterbalance lower access to equity and bond buyers.

Dealogic estimates that US E&P companies borrowed $105.4bn through syndicated facilities last year, up by 66pc from the previous year and the highest annual total since 2014.

Another positive is there does not appear to be an excessive wave of loan maturities due in the near future, which lessens the sector's bank-debt refinancing risks. "The upstream sector has done a good job of pushing out maturities into 2022-23," explains DI Capitalize.

Traditional bank lending has also been supplemented by non-bank debt providers, which typically charge significantly higher interest rates. George stresses that, when considering the use of higher-cost debt, it is essential to pair it with higher-returning projects. "When the equity markets are not there, you have got to borrow, and borrowing can be expensive, so CFOs and operators have to be really diligent about matching operations and drilling to the capital that they are using."

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