In a time of high economic uncertainty and significant disruption in the energy industry, oil and gas producers need to both play it safe by focusing on a core set of tactics to deliver value now while also doubling down on growth aligned with their company’s future. Investment and divestment strategies can be a differentiator in times like these. As 2020 gets underway, a majority of producers find themselves considering their options to raise capital, invest toward long-term value or restructure to position themselves for success today and in the future. 

1. Raise capital 

Cash-strapped producers may consider portfolio realignment, divesting noncore assets and getting creative in raising capital through non-traditional financial methods. Traditional financing methods, such as an IPO, or debt financing through banks or other lenders, may not be an option in today’s capital-constrained market. These producers will need to take steps today to improve their capital structure while also finding ways to collaborate and engage with others in the sector to create efficiencies and drive out costs.

Key questions these companies should be asking include: 

  • Is capital allocated in a formal, systematic process that allows for adjustment?
  • Are divestments being considered, along with regular evaluation of the business and assets to ensure maximum return?
  • Where can business models and functional groups be optimized to drive out costs?

Additionally, private equity will continue to be an important source of capital. Producers may consider entering new arrangements as an opportunity to raise capital or free up cash. Drilling joint ventures, called DrillCos, have risen in popularity in recent years as a way E&P companies can raise capital while maintaining cash flow. Although complex arrangements, DrillCos allow an investor to provide development capital in exchange for a working interest in a specified property or area. Other nontraditional arrangements, such as infrastructure and cash-and-carry transactions, are also being evaluated as options to improve cash flow and manage balance sheet obligations. 

Further, companies looking to position as an attractive acquisition target should tailor their sell-side proposition to attract a wide and varied buyer pool and focus public and private dialogue on solid fundamentals: a well-positioned portfolio and attractive operations. To not limit the buyer pool, a company needs to identify synergies for potential financial or strategic buyers. For example, companies should consider general and administrative (G&A) costs and potentially costly lease and marketing agreements—a detail more than a few companies overlook.

2. Invest toward long-term value 

As societal pressures mount on decarbonization, oil and gas companies are challenged with balancing short-term and long-term performance. Growing concern about the long-term oil and gas outlook have led to depressed asset valuations. Well-capitalized producers are positioned to add solid assets to their portfolio while holding down costs—provided they proceed with caution. An EY analysis of industry earnings calls showed that analyst questions centered on returning value to shareholders and concerns about profitability—a far cry from years past when costs were largely ignored in the face of high oil prices. For companies looking to augment their asset portfolio, 2020 presents numerous intriguing options. Increasingly, we’ll see companies rationalizing portfolios and searching for greater capital flexibility as they look for opportunities for profitable growth.

If a company wants to retool for long-term value, it needs a calculated distressed-asset strategy and demonstration of how it can operationalize the value of those assets in a cash flow-accreditive way—versus simply pointing to the amount of acreage acquired. Companies should also implement a strategic review process for high grading their asset portfolio and potentially off-load some noncore businesses or assets, as needed. While any number of these complexities will continue to emerge in this transition, companies with a clear sense of their core values should develop a sense of how to augment their operations and products and be willing to take bold action when opportunities arise.

3. Consider financial restructuring

Finally, some producers find themselves with looming debt maturities that are forcing their hand. Growing economic uncertainties are leading lenders to reassess risk across the board, but especially in the oil and gas sector. The general underperformance of the sector vis-à-vis broader equity markets and the decoupling of company valuations from the underlying oil prices has led to a significant increase in the cost of capital for oil and gas companies. Energy high-yield spreads have doubled from where they were a year ago. At the end of 2019, increasing financial pressure put more assets under distress and bankruptcies (46), which were up 48% from 2018 (31), according to the latest EY Global Oil and Gas Transactions Review. While the specter of bankruptcy carries an unnecessary stigma, often the protections of bankruptcy are just what a struggling enterprise needs to retool for a successful future.  

However, bankruptcy is not the only option. Companies can consider out-of-court financial restructuring options such as debt restructuring, co-investing opportunities and divestments. Many factors should come into play in determining the right path. First, clarity about the business and an optimized asset portfolio are necessary. Cost and structural factors that could substantively affect recovery are also key considerations. G&A costs must be lowered, particularly as the industry continues to innovate with digital technology. Demonstrating fiscal discipline and capital efficiency will also be vital in rebuilding investor confidence and trust.  

No matter the path, short- and long-term vision is crucial 

Even as uncertainty reigns, some fundamentals always ring true: a strong balance sheet is the best antidote to economic uncertainty; capital efficiency and a well-managed portfolio will create opportunities; and a company’s core differentiators and value-drivers should guide all acquisitions. 

Strategy around those core values, including a vision of the future of the company amid longer-term energy transition challenges, is also critical. While the current environment occupies the lion’s share of many producers’ decisions, the energy transition—a fundamental revolution in how we view and utilize resources—is threatening to change the industry at breakneck pace. A nimble approach to portfolio management to avoid potential pitfalls and take advantage of emerging opportunities will be key.

Oil and gas companies willing to play it safe or double down will position themselves to capture value now and in years to come.

Kris Anderson currently serves as a principal in Ernst & Young LLP’s transaction advisory services practice in Houston and is the EY US Oil & Gas Independents Leader. Anderson serves clients across the energy sector with an emphasis on valuation and corporate finance issues related to mergers and acquisitions, divestitures, restructuring and reorganization, and strategic decisions.

David Johnston is a transactions partner responsible for providing valuation services to clients in the oil and gas and mining and metals sectors for financial and tax reporting purposes. As a trusted adviser, he currently works with some of the biggest companies in oil and gas as they weigh strategic executions in the current energy market.