[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.]
Capital access and formation in the oil and gas industry continued to be challenging for even the most established players throughout 2019 and into the early months of 2020. The energy sector’s share of the S&P 500 has fallen to the lowest point in 78 years, reaching as low as 3.3% of the total S&P 500 as of March 9, 2020, down from 15% in September 2014. Equity issuances by publicly traded energy companies in 2019 were at their lowest volume since 2002 with $7.6 billion of equity capital raised, and upstream oil and gas companies accounted for only $0.5 billion of the total. Investors in publicly traded E&P equities are now focused almost exclusively on free cash flow, demanding that companies generate and grow free cash flow in a low commodity price environment and return “excess” cash flows to shareholders or use the proceeds to de-lever.
In addition to the difficult public, and private, equity markets, borrowers that rely on reserve-based lending (RBL) to fund their operations are now facing a broad tightening in banks’ borrowing base determination criteria, further stressing already strained balance sheets. Many borrowers and lenders anticipate a new round of reductions in borrowing bases following the spring redetermination cycle as banks have become more conservative, with some banks working to actively reduce their oil and gas RBL exposure or even exit the market altogether.
To make matters worse, capital availability for oil and gas companies is increasingly affected by broad climate change concerns and the resulting pressure on institutional investors to be mindful of the perceived environmental, social and governance (ESG) impacts of their investment decisions. Asset management firms, pension funds, banks and other traditional sources of institutional capital for the industry are scrutinizing oil and gas investment opportunities much more closely against the backdrop of ESG concerns, and as a result, a further constraint on capital availability has emerged.
And yet RBL redeterminations and the pullback of traditional lenders in the RBL space, along with the lack of investor confidence on Wall Street compounded by ESG pressures, are only a part of the problem. Poor capital market and commodity price conditions, the pressure on companies to return capital to shareholders, and tightening credit markets have depressed equity and asset values across the board, in turn constricting the ability of private equity to fill the capital void. But capital for growth—or survival—is required now more than ever, which means companies will need to look to alternative avenues for solutions.
Balance sheet optimization tactics
As part of companies’ search for solutions, balance sheet optimization may become a more prevalent tactic. With restructurings on the rise— third-quarter 2019 saw an increase of 186% in bankruptcies year-over-year—lenders are scrutinizing balance sheet health and demanding leaner, less risky capital structures, resulting in borrowers taking multiple steps to strengthen their balance sheets in order to position themselves to access additional capital sources.
As a result, debt exchanges may be an option for some companies. In these transactions, companies may offer to exchange existing outstanding notes held by investors for new notes with different terms such as a reduction in principal, a new interest rate, an extended maturity date or an equity conversion feature.
Debt issuers could also conduct debt-for-equity swaps, offering existing noteholders equity securities in the issuer or one of its affiliates in exchange for outstanding notes. If there is cash available on the balance sheet as a product of operating cash flows or asset sales, an issuer could also consider taking advantage of low market pricing of its outstanding debt and repurchase and retire notes to de-lever the capital structure.
With restructurings on the rise—third-quarter 2019 saw an increase of 186% in bankruptcies year-over-year—lenders are scrutinizing balance sheet health and demanding leaner, less risky capital structures.
These alternatives could be a good fit for companies with available liquidity that want to reduce their indebtedness and improve their leverage metrics.
To the extent that reducing the company’s leverage ratio increases the company’s appeal to lenders by reducing the interest rate and default risk of the existing debt, a company interested in accessing different capital sources may consider restructuring its balance sheet to take advantage of investors’ calls for de-risked capital structures.
Healthy enough for high yield
For those noninvestment grade companies with capital structures that are still healthy enough to take on additional debt, issuing high-yield notes may still be an option, although recent trends in the energy high-yield market have shown that investors are shying away from high-yield notes in the same manner that investors are pulling out of the private-equity-market investing in the energy industry. In fact, energy high-yield volumes in 2019 were the lowest since 2009 with only $19.6 billion raised.
However, despite the challenging energy high-yield market, some upstream companies (Viper Energy Partners LP, Endeavor Energy Resources LP and Murphy Oil Corp.) were able to get deals across the finish line in fourth-quarter 2019, for total proceeds of $1.45 billion.
With the outlook for the energy sector expected to stay depressed at least into 2021, prospective bondholders are likely to demand steep pricing and tight covenant packages. Nevertheless, the issuance of high-yield notes may be an option for producers with lower leverage that want to pay down their existing revolving credit facility or redeem existing high-yield notes that are to mature in the near term.
For those noninvestment grade companies with capital structures that are still healthy enough to take on additional debt, issuing high-yield notes may still be an option.
For example, in February 2020, Parsley Energy Inc. issued $400 million of 4.125% senior unsecured notes due 2028 and used the net proceeds from the offering and borrowings under its revolving credit facility to redeem all of its outstanding 6.25% senior unsecured notes due 2024.
Second lien considerations
Second lien debt may be an option for companies with the collateral pool necessary to satisfy a second lien lender. Some companies have relatively flexible covenants in their first lien debt that may
allow them to incur additional funded junior debt. Companies with significant unencumbered oil and gas properties sufficient to provide enough collateral security to second lien lenders may be able to take advantage of second lien debt incurrence to create liquidity and fund development beyond what can be financed with operating cash flows.
However, lenders will likely demand premium returns in exchange for the risk associated with junior debt in an industry beset by an uncertain commodity price environment and the resulting impact on cash flows.
While second lien debt may be a viable option for an E&P company with a favorable RBL, a prospective borrower should have a high level of confidence that it will generate enough cash flow to service the additional debt and have the collateral coverage necessary to maintain second lien debt covenant compliance for the life of the facility.
Because commodity pricing is currently weak and volatile, special consideration should be given to the certainty of that producer’s cash flow.
This alternative could serve as bridge financing to close cash flow gaps for companies with healthy balance sheets positioned to endure through to market correction and a return to commodity supply-demand equilibrium.
Asset level financing comeback
Following the precipitous decline in oil prices commencing in late 2014, asset level financing structures increasingly gained traction in the oil and gas industry. While setting up these structures involves more complexity than many in the industry prefer (e.g., navigating restrictions in governing debt instruments, third-party consent rights, pref rights, governance, investor exit and regulatory issues, etc.), they may offer both producers and investors desirable benefits.
Asset level financing structures vary widely. Drillco participation agreements, in which a capital provider funds the drilling of a portfolio of wells, offer a recently popular example. These agreements typically include a carry for the operator and a reversion feature such that after the financed wells generate a specified internal rate of return for the investor, the investor’s working interest reverts to a smaller final interest in the wells.
Other examples of these structures include the sale of overriding royalty interests carved out of the operator’s working interest (i.e., interests in a specified percentage of the hydrocarbons where the overriding royalty interest owner has no obligation to pay development or operating costs); sale of net profits interests (i.e., a species of overriding royalty interests where the investor’s share of production proceeds is calculated net of operating costs paid by the operator); and volumetric production payments, which represent an ownership interest in scheduled future production volume from an identified asset or assets.
With capital coming in at the asset level, producers and investors can focus on assets in a particular field or a particular class of assets, thereby insulating the investment from the operating results of other assets that may not be as financially attractive and, to some extent, mitigating operator credit risk.
However, in these types of deals, certain fundamental risks are transferred to the investor, specifically reserve, production and commodity price risk. These types of alternatives were not as widely utilized during 2019 as they were from 2015 to 2018, but these structures may see a comeback in select situations.
Securitization: a new niche?
In addition to these more familiar financial structures, oil and gas securitization is a recent emerging financing structure in the upstream space. Raisa Energy LLC, a portfolio company of EnCap Investments LP, completed the first oil and gas securitization in September 2019 and Diversified Gas & Oil Plc completed the second in November 2019. While there have not been any announced oil and gas securitizations since the Diversified transaction, many producers and their sponsors have been exploring this structure as a new potential source of capital.
In a securitization, a company can access nonrecourse debt capital serviced solely out of future cash flows from the securitized assets. In an oil and gas securitization entered into to raise capital resources, a producer would form a subsidiary as a bankruptcy-remote special purpose vehicle (SPV) and would sell and transfer producing wellbores, or an undivided interest in the wellbores, to the SPV.
The SPV issues fixed-rate amortizing notes to investors in a private placement and in turn the SPV distributes to the producer the net cash proceeds as the consideration for the sale and transfer. In connection with the notes issuance, the SPV grants a mortgage over and a security interest in its wellbore interests to an indenture trustee in favor of the investors in the notes offering.
In addition, a high percentage of the future production from the wellbores must be hedged for the expected life of the notes. Typically, the hedging, combined with the fact that the financed assets are segregated from the credit of the sponsor, allows one or more independent rating agencies to give the notes an investment grade rating.
Oil and gas securitization is a recent emerging financing structure in the upstream space … [that] many producers and their sponsors have been exploring … as a new potential source of capital.
Oil and gas securitizations hold several advantages over traditional RBLs or other secured debt financings (such as second lien loans). To name a few, there are no redeterminations; there is likely a higher available advance rate against the PV-10 of the securitized assets; the interest rate is fixed; and the debt is nonrecourse to the producer. In addition, there are no financial, and limited other, covenants.
The securitization structure itself imposes no restrictions on the sponsoring company’s use of the debt proceeds. A percentage of excess cash flows (i.e., cash available after the debt service and satisfaction of hedge settlement and other priority payments established in the indenture “waterfall”) may be returned to the sponsor on a current basis.
An oil and gas securitization transaction may be appropriate for producers with mature, PDP assets with predictable cash flows that can benefit from monetization of the future cash flow at an attractive valuation.
The authors are based in the Houston office of Sidley Austin LLP. Jon W. Daly is a partner in the global energy and infrastructure practice where he represents public and private companies, investment banks and private-equity firms in connection with IPOs, M&A, private-equity investments and registered offerings and private placements of equity and debt securities. Kaitlin Schock is an associate in the global energy and infrastructure practice advising on energy and corporate matters. Sidley partners James L. Rice III and George J. Vlahakos also contributed to this article.
This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create and the receipt of it does not constitute a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.
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