David Sweeney and Sarah Schultz, partners with Akin Gump’s oil and gas and restructuring practice groups in Houston and Dallas, discuss the current state of the industry, and how oil and gas companies are navigating these turbulent times.
What activity are you seeing in the oil and gas landscape right now, and what insights do you have about what might be fueling it?
David Sweeney: We all know what’s going on with COVID-19 right now and the effect it’s having on the economy, but the traditional fossil fuel energy space has been hit by a double whammy. We already had low demand. People look at pre-2014 and think of that as normal, when oil was $100 a barrel, but that hasn’t been the case in years. COVID-19, however, has exacerbated that. We’ve had relatively low demand, plus a lot of relatively easy money, and the result has been considerable oversupply.
Unsurprisingly, that means low prices. A very prominent trader made a comment in the news some time ago that called negative oil prices. Obviously circumstances for many are fairly dire, and, for the oil and gas industry, this may not be alleviated by the end of social distancing. These problems are much more deeply seated.
It affects different companies in different ways. Let’s divvy the oil and gas world up into two broad categories. You have the majors and the independents. I would break the independents into three different tiers. Tier ones are large companies with large, multi-basin assets that may or may not have international assets. Then, you have tier two, which are midsized. They have much less in the way of asset diversity and may even be pure-play. These companies tend to have a higher debt load Tier three is occupied by smaller, general private equity sponsored companies. The midstream and service and supply sectors can be parsed in a similar way. Tier 1 companies have the asset base to manage their debt loads and keep assets in place and will likely survive this (and may even grow). The outcome for Tier 2 companies is fact-dependent – can any particular company transact to manage its debt load and keep leases from expiring? A lot of Tier 3 companies are going to have to do some fancy dodging to survive.
The industry has become increasingly overcrowded and overleveraged. Not to editorialize, but perhaps too much debt was taken on based on a “lease and flip” model. Never mind whether the company worked in terms of making money from its core business, production of barrels of oil and net cash flow of gas.
What are some common restructuring themes you are seeing among private and public companies?
Sarah Schultz: We’ve spent a lot of time, even before the current crisis, restructuring oil and gas companies. In many cases, those restructured companies maintained the absolute maximum debt that they could post-restructuring, sometimes with the assistance of their lenders, because it made it easier to get the deal done. As oil prices have fallen again, we’re seeing companies that cannot produce economically. Their general and administrative (G&A) expenses are not supported by their production, and they are simply not going to be able to continue to be viable.
We’re seeing these companies, some of whom already restructured in the last 12 to 18 months, come back to the market and acknowledge that they need to restructure again. In some cases, we’re seeing a true, traditional restructuring. We’re seeing stakeholders who are willing to equitize, which is more of a traditional restructuring, or those who are willing to recast their notes into a longer tenure, or at a different in interest rate, etc. Those options are available for larger companies, companies that have a solid management team and, frankly, are primarily being impacted by the crumble of commodity prices that will need some time to recover. So I think that traditional restructuring may continue to be available to companies that are in a position to recast their debt in such a way that it gives their creditors – and in particular their funded debt – a piece of paper that trades closer to par. We saw this with Whiting Petroleum. We’re seeing it with some other cases as well, and it looks to us like the ones who are going to be the most successful are those that limit the amount of time spent in Chapter 11. That’s not unusual, of course; typically cases are the most successful that way. However, this route, traditional restructuring isn’t going to be available to every company, perhaps for quite some time.
The other thing we’re seeing is consolidation, in a couple of ways. There are all of these companies out there that have pools of assets, and in many cases, we’re seeing that their G&A expenses far exceed what they should be. So we’re seeing consolidation, via mergers and acquisitions (M&A), and frankly, in this market, we’re seeing tremendous downward pressure on price. For example, take a company with an asset purchase agreement that had a $330 million face value on it before COVID-19. That could be adjusted downward by $100 million in this new climate. There are large purchase agreements that are going to be terminated or otherwise renegotiated given the changes in the market. The other thing that we’re seeing in the traditional M&A space is that the capital markets are generally not available for fossil fuel purchases. I have a client who was prepared to make an offer on some assets, and he went to his bank and asked, “What can I get? What kind of availability do I have?” And the answer, unfortunately, was “not much.” And it’s not that the client was a particular credit risk or anything like that – just that the capital markets are not prepared right now, whether it’s through traditional bank lending or otherwise, to invest more in the fossil fuel market, given the current volatility.
What are some other options for addressing these issues that the industry is currently facing?
Sweeney: That’s the million-dollar question – or actually, the billion or trillion-dollar question, depending on who’s asking, depending on what level we’re talking about. You’ve got traditional M&A, which, as Sarah was saying, has dried up in a way that is pretty unprecedented. So that creates an interesting state of affairs. Restructuring is another solution if it’s implemented correctly.
There are political solutions as well. The Texas Railroad Commission is contemplating prorationing, which hasn’t been done for a long time. It’s hard to say how it would work in practice now. If you’ve ever seen a picture of Kilgore, Texas, from that era, for example, the legs of the derricks were literally touching each other because people were drilling so closely together and damaging reservoirs. The Railroad Commission in essence limited production and implemented well spacing and density rules.
The Railroad Commission – and the industry generally – is divided about this issue. Some independents who are heavily weighted toward Texas production, specifically in the Permian Basin, are very much in favor of prorationing, but I think there are going to be a lot of other people howling about it, if it actually ends up happening. Letters to the Railroad Commission offering testimony for and against have actually been published on its website. These are a fairly interesting read. There are other actions being considered as well, such as limits on flaring gas, that are arguably easier to implement and might have a similar effect, albeit with consequences allocated in a different way. In the short term, however, there are a lot of companies that are in quite a bit of trouble. Immediate and urgent restructuring, in many cases, may be the single best solution. The best thing that companies can do right now is engage with their stakeholders, and do it frequently, because that does more for an orderly restructuring or rightsizing of your particular company than any political solution will.
Schultz: Absolutely, it’s imperative that these companies engage with their shareholders and stakeholders, because right now a lot of them are looking at a portfolio that’s has a substantial amount of its value dissipate literally overnight. Anything that these companies can do to provide stakeholders with a measure of increased recovery is something that will be very well received. What I caution companies against doing is waiting too long. If you wait too long to start engaging with your stakeholders, you’re going to be left with one play in your playbook, and that tends to be a disposition of assets, which is unfortunate because oftentimes there are alternatives that would have been available to the company had they’d engaged early on.
What is the current appetite for financing deals or infrastructure projects?
Sweeney: There’s a sentiment out there in the banking industry called “extend and pretend,” which is the idea that if you just put a company into a state of stasis – don’t do anything, cut G&A to the bone – you can absorb some level of losses, maybe get a bit of help, then come out on the other side after there’s been a bunch of consolidations and/or restructurings and/or liquidations and be both healthier and an attractive acquisition target. That may not be a realistic solution in the oil and gas industry though.
Schultz: Right, in other industries, extend and pretend is potentially viable, if you can shutter a lot of your costs and bring your overhead and your G&A in line. But in this industry, in particular, a lot of companies are already running on incredibly narrow margins. There just isn’t a lot of wiggle room for them, because the market was already in a very low trough as relates to commodity pricing, and frankly we’re in unprecedented territory now.
The other problems that we’re seeing are the environmental liabilities associated with these assets, as well as real safety liabilities. Boards of directors and management teams need to be careful that they don’t create a situation where the business is operating at such a razor-thin margin that it doesn’t have the ability to respond to a busted pipe or a blown-out well. These types of scenarios can create a very significant liability if they can’t respond appropriately.
We hear a lot of people saying, “Well, maybe they should just stop producing.” The problem with that is that in a lot of instances their leases are held by production. So as soon as you stop producing in paying quantities, your lease goes away. You’ve got these small companies that have built these large portfolios of oil and gas leases, and if they can’t afford to produce, the net result is that their underlying assets revert back to the mineral owner. I just don’t know that it’s a viable option for most companies in this market environment.
Sweeney: I have seen advertisements on LinkedIn and other social media platforms for litigation-type lawyers who are trying to drum up clients who want to terminate leases. The United States is unique in terms of its oil and gas exploration and production industry in that you have leases that will expire if they don’t continue to produce in paying quantities. This is in contrast to a lot of the rest of the world, where the government owns and controls the oil and gas in the ground, and operators have more of an ability to produce - or not - without working about assets terminating. Elsewhere, you likely have one landowner- the government. Here in the U.S., you can have thousands of owners per well. It certainly has made the U.S. model more profitable during the best of times – and there are reasons why the industry is so different in this country, both the good and bad, and private mineral ownership are a big part of that. But in the worst of times, which we’re certainly in now, the U.S. model encourages things like a lack of coordination and supply overhang. We’ll have to see how things play out in the next several months. As with everything right now, there are just a lot of unknowns.
Published May 26, 2020.
