[Editor's note: A version of this story appears in the 2020 edition of Oil and Gas Investor’s Capital Formation. See more stories like this here.] 

Searching for capital sources in energy becomes a lot harder when it’s believed that the industry landscape can’t get any worse—and then it does. Big time.

WTI closed at more than $61/bbl on the first trading day of 2020. At the end of the first week fol­lowing the failure of OPEC talks—and the outbreak of a price war between Saudi Arabia and Russia—WTI had plummeted to a little over $31/bbl.

By the middle of the next week, WTI collapsed into the low $20s and within pennies of $20/bbl.

Public-equity markets for energy, of course, have been closed for some time. Debt issuance has been largely bifurcated, with the market effectively shut for high-yield issuers, as existing high-yield issues in some cases trade at rates higher than in February 2016, when WTI fell to as low as $26.14/bbl.

Meanwhile, upcoming reserve-based lending (RBL) talks will undoubtedly involve some tough decisions. One major bank took charge-offs not an accounting write-down, but a real financial loss—of between $750 million and $1 billion in 2019. The adverse conditions are expected to continue for the majority of 2020.

While a variety of other forms of financing exists, they often come with more restrictive con­ditions. First lien term loans, at times used in a manner akin to bridge financing, carry in one case a covenant of no greater than 60% loan-to-value. The term of the loan may be measured in months or a few years.

For speakers at Oil and Gas Investor’s Energy Capital Conference in Dallas, which took place earlier in the week that ended with the OPEC conference, the outlook was far from rosy. Little did they know that the worst was yet to come.

Nonetheless, even as market sentiment offered only occasional upbeat surprises, speakers pro­vided key insights into their respective markets from an analytical or capital provider perspective.

Bill Lambert, Goldman Sachs
“The very large companies could potentially come in and scoop up some very good companies in that middle tier of name," according to Bill Lambert of Goldman Sachs Natural Resources group.

Bill Lambert, managing director of invest­ment banking with Goldman Sachs’ Natural Resources group, struck a realistic tone regarding investors’ priorities.

“On the equity side, investors want to see the return of capital, and they want to see that in the form of consistent free-cash-flow generation,” said Lambert. “On the debt side, for those coming in on a new issue, it’s really a case of ‘Where am I going to be safe? And what price is appropriate for that safety?’”

Lambert recalled energy issuers coming to the debt market earlier in the year, and “the concern is that those issues are trading pretty terribly now. As they’ve traded down, a lot of those people who you need to be part of a deal—the folks that are the liquidity in those deals—have been burned pretty badly.”

As a result, the market is “relatively scared from a new issuance standpoint,” he said. “When you look at the secondary trading levels, there are a number of companies that a few weeks ago were trading 85 to 95 on the debt side, and now they’re trading much, much lower than that. The velocity of change has made people withdraw and simply wait and see as they watch the wall of maturities coming up.”

Years, not quarters, of FCF

Investors are interested in a better understand­ing of the sustainability of free cash flow (FCF), according to Lambert, and to what extent FCF and growth—say, flat production growth up to 5%—are compatible.

“Potential investors are saying, ‘Show me so I can see your growth, so I know how your asset works and how it generates more free cash flow,” he said. “‘And get your balance sheet in shape. Show me that over a couple of quarters, and then I’ll come back.’”

In addition, the ability to offset declines, reg­ister growth and now generate FCF is a focus, Lambert added.

“The difficult part of flipping a switch from growth to free cash flow is that it’s exceptionally hard for any company,” he said. “Part of the challenge the whole industry faces is that for the past 10 or 15 years we’ve been telling investors how repeatable, how high return, how easy shale is. But base declines are steeper and more challeng­ing than a lot of people wanted to admit.”

Neal Dingmann, managing director of energy research with SunTrust Robinson Humphrey, also highlighted FCF generation as a hot topic.

“Investors need to see sustainable free cash flow,” said Dingmann. “It’s not hard to generate free cash flow for a quarter or maybe even a year for some of these companies. Even if I can show clients that some companies are able to generate free cash flow for 2020 and 2021, they still want to see that for a longer period of several years. What they want is some assurance that they have some sustainability of free cash flow.”

Catalysts for returning E&Ps to favor

Discussing how E&Ps can find favor, Dingmann said, “In my opinion, it’s going to be sustained outperformance by the group that’s going to turn it around, which we haven’t had for some years.

Neal Dingmannm SunTrust Robinson Humphrey
“A lot of the expenses in general [for many companies] are still entirely too high for the environment we’re in," said Neal Dingmann of SunTrust Robinson Humphrey.

“When energy stocks work, they start really working in a material way. It’s unfortunate, but we haven’t seen that in the past several years,” he added.

In addition to outperformance in terms of returns, Dingmann cited other catalysts: broader ownership, FCF, low leverage and “moderate” growth.

Looking at stocks sorted by play, “what’s note­worthy is that it doesn’t matter in which play these E&Ps operate; nearly all of them under my coverage are down by a large amount,” Dingmann said. “It doesn’t matter what the market capitaliza­tion may be; all of the stocks have been run over. There’s been nowhere to hide. And there’ve been few signs of life. It’s been brutal thus far.”

In terms of ownership, growth-focused funds remain the largest holders, with 37% of overall institutional ownership, according to SunTrust. By comparison, passive or index funds make up 20% of overall institutional ownership of stocks covered by SunTrust, while value-oriented funds represent just 13%.

“We talk about a lot of value in these stocks, but when I go to New York, I end up being with a lot of growth clients that are interested in when it’s time to be ‘back in the game,’” Dingmann said.

As for prioritizing FCF, “at $65/bbl, most of these E&Ps are generating very nice free-cash-flow yield, as you would expect,” he said. “Unfortunately, at $45/bbl and lower, very little of my coverage is doing that. My conclusion is that a lot of my companies, when you look at their G&A [general and administrative], at their operating costs, etc., a lot of the expenses in gen­eral are still entirely too high for the environment we’re in.

“And that is being solved by these companies, or they’re not going to be around,” he said.

“Investors want to see shareholder returns in general,” but favor dividends, according to Dingmann. “Dividends are a little more measur­able to them,” he said.

In a choice between dividends and stock buy­backs, “the hard part of a stock buyback is you often have just one bullet,” he said. “Some E&Ps have bought back a material amount, only to see their stock down another 30% to 40%. What are they left to do then?”

Low leverage is also a priority, “since free cash flow is irrelevant if leverage is not in check,” Dingmann said. Moreover, “red flags” go up, he noted, if there are near-term maturities without a clear line of sight of ample cash to pay them down. “We see debt markets for newly issued notes as mostly closed, while the market for refi­nancing is available to larger, high-quality names,” said Dingmann.

Ray Lemanski, KeyBanc Capital Markets
“[Investors] want free cash flow. They want reduced leverage. And they want at least a modicum of growth. But there’s only so much cash that can go around to meet all those priorities," said Ray Lemanski of KeyBanc Capital Markets Inc.

Debt service, then the rest

Like other investors, “bond investors are looking for sustainable free cash flow, too,” according to Ray Lemanski, managing director and head of credit research with KeyBanc Capital Markets Inc.

“Investors are looking for three things, which in some degree are in conflict with one another,” said Lemanski. “They want free cash flow. They want reduced leverage. And they want at least a modicum of growth. But there’s only so much cash that can go around to meet all those priorities. Obviously, the most immediate priority is debt service.”

Lemanski said the market has changed over the past 12 to 18 months or so as to “what constitutes acceptable leverage. The number keeps going down. Right now it is probably around 1.5 times, and there are still a number of companies in that lower tier of stressed/distressed companies that have a ways to go to get there,” he added.

“The issues concerning credit relative to E&Ps have been predominately in the high-yield market and, arguably, only in the lower credit tiers of the high-yield market,” according to Lemanski.

A graph presented by Lemanski shows the relative spread between three indices: the overall high-yield index; the broader energy high-yield index, which covers all components of energy related to high yield; and the index spe­cifically related to the E&P sector in high yield. In 2013 they all traded in a tight range of 5% to 5.3%, and high yield related to E&P traded within 30 basis points of the overall high-yield index. The differentials peaked in January 2016.

“More recently, you can see the deterioration that has taken place in the E&P sector,” said Lemanski.

As of late February, the overall high-yield index has traded down to yield 5.84%. But the broader energy high-yield index has traded down to yield as much as 10.31%, while the E&P high-yield index has traded down even more for an aver­age yield of 14.01% yield. During the course of March, the spreads have widened again.


Increasing Differential Between E&P And Broad High Yield
As investor sentiment further sours against the energy sector, the differential between the broad high-yield index and the E&P index continues to increase. (Source: Morgan Markets)

The stressed/distressed sector “can be hurt by two factors,” Lemanski said. “High-yield E&Ps make up a disproportionate amount of lower-rated credit sectors in the high-yield market. So when the market goes to ‘risk off,’ the sector is going to be sold hard. This is usually accompanied by a decline in the commodity price, so it’s a double whammy that these companies experience versus similar credits in other industries.”

Credit access feasibility, likely outcomes for E&Ps

So how likely is it for companies to gain access to credit markets in energy—whether it’s for higher-quality issuers or high yield?

Given the coronavirus pandemic, and then the abandonment of quotas at the recent OPEC meet­ing, “No one really wants to test the market. It’s just not worth it,” Lemanski said.

“If an issue is trading around 8% or a little higher, and we have some easing of the coronavi­rus uncertainty, a company may likely be able to come to market. Most of the companies that have traded well have at least one BB among its rat­ings. The problem is really centered on the middle of the single B-rated universe and below. So the answer is ‘yes’ for some and ‘no’ for others.”

Given the recent spike in high-yield spreads over U.S. Treasuries, Lemanski said, “Usually you’d tend to draw some interest from the more distressed investment community. That hasn’t happened, at least to date. I think the reason why is that a lot of investors tried to make a stand a little too early in the 2015 to 2016 sell-off, and they really got their fingers burned. They’re going to be more hesitant.”

However, in instances where some compet­itors are underperforming the sector leaders, “That typically suggests there should be con­solidation—basically cleaning up the bottom,” commented Lemanski. “So far, that’s not hap­pening now, largely because there has to be a consolidator. And the majors, at least to date, have not shown interest in fishing down in these small ponds.”

Among better performing, larger companies, the equity values of the companies “aren’t such that they really make the deals possible,” said Lemanski. “And right now there’s not a lot of money in the debt market and, to some extent, even the bank markets during previous deal times. To the extent that starts to change, a lot of these small companies ultimately need to go away. They need to consolidate.”


Three Ways Of Looking At The Debt Wall

Looking at the pending maturity wall for pro­ducers in the high-yield space, Ray Lemanski, managing director and head of credit research with KeyBanc Capital Markets Inc., separated issuers into three categories.

“The first is what I would call ‘market rate.’ This comprises issuers that should be able to refinance in a more normalized type of market, typically on a yield-to-worst of around 8% or lower, such as Diamondback Energy Inc., Parsley Energy Inc. and compa­nies like that,” said Lemanski.

“In the middle, you have companies that are trading at yields of 8% to 13%. And that’s an area where, with a recovery in the high-yield market overall and some help from the oil price, the companies should be able to handle the maturities coming at them reason­ably well,” he said.

“And, in any case, the maturities don’t really start building up until 2025, which from a market standpoint is forever,” Lemanski added.

“Third, in the stressed/distressed category, these credits are ones that are having financial issues, and the market is losing confidence in them,” he said. “The 13% and higher yield-to-worst is kind of an arbitrary choice, but not a bad one. It goes to the stress level— for example, when the price of the bond and the yield of the bond are fairly close to each other. These are companies with much more significant credit issues.”


Categories Of Issuers Facing Debt Maturity
The volume includes all domestic, USD-denominated high-yield (including split-rated) issuance. More than 70% of E&P bonds maturing through 2023 are stressed/distressed, though some issuers can still access the high-yield market and more should be able to if the market improves. (Source: KeyBanc Capital Markets, Bloomberg)

Beyond consolidation, there are still a few options, but they pose their own difficulties, the speakers said.

“For some of the companies that may be on the cusp, and not irretrievably damaged, there may be a role for private credit,” Lemanski said. “It may be in conjunction with a deal worked out with the bondholders, where they may backstop some exchange offers, take out the RBL completely, do a first lien term loan, which may have bondholder and private credit partic­ipation and try to ride this thing out.”

Meanwhile, E&Ps at the bottom of the tier “will have an unavoidable encounter with some form of restructuring of the balance sheet. It could be in court or, more likely, out of court,” said Lemanski.

“I think the guys in the middle tier have the abil­ity to hang in there for a while, until the process works itself out, and they can hang in there and ultimately do a little better,” he said.

Lambert from Goldman Sachs also offers a pos­sible outcome.

“We think a number of the very large companies could potentially come in and scoop up some very good companies in that middle tier (yielding 8% to 13%) of names. Some of the companies below may unfortunately be too far gone,” he said.

“What we’ve seen is that when you try to do a deal and have two sets of equity investors arguing over valuation—and you have to incorporate the debt investors because the debt probably won’t get back to par—it makes those deals exception­ally hard to get done.”