High yield and leveraged loan values for the energy sector in North America and Western and Southern Europe halved in Q1 2020 when compared to figures for Q4 2019, from US$40.9 billion to US$21.9 billion.
Power companies have been relatively resilient, but there is little prospect of a rebound in Q2, with capital markets remaining a challenge, especially for oil & gas borrowers.
The oil & gas industry was already on the back foot before the COVID-19 outbreak thanks to a period of prolonged low oil prices. Oil prices dropped by half in the past 12 months. Price wars between major producers Saudi Arabia and Russia allowed excess supply to flood the market at the same time as COVID-19 lockdowns saw demand spiral. These headwinds pushed many issuers in the sector over the edge and diluted what was left of investor confidence.
Oil & gas loans were already becoming increasingly distressed before COVID-19 began to bite, trading at 80% of face value on average, but the unprecedented fall in demand and a depressed oil price has seen the average pricing figure slide to 50%.
The amount of US oil & gas speculative grade debt in distress has doubled to US$72 billion since the start of the year, according to ratings agency S&P. Defaults are creeping up and downgrades have occurred and are expected to continue.
The sector will be a driving force for bankruptcies for the foreseeable future, based on data from Debtwire Par. Seven oil & gas companies in the US filed for Chapter 11 in the first three months of the year. In April alone, six of the 25 Chapter 11 filings were oil & gas businesses, including Whiting Petroleum and Diamond Offshore. This trend continued in May, with the sector representing 22% (eight of 37) of all Chapter 11 filings.
Opportunities are still available for some
Despite a difficult backdrop, a handful of oil & gas businesses with strong balance sheets have been able to shore up their capital reserves with new lending. Beginning in mid-March 2020, a select group of large global players managed to raise new debt.
ExxonMobil, Royal Dutch Shell, BP, Equinor in Norway and Total in France secured more than US$32 billion in lending among them.
The oil majors have used every available option to increase their cash reserves to protect shareholder dividends—including cost cutting and freezing share buybacks. A few cash-rich players have also pursued M&A strategies, including Total, which acquired Tullow Oil’s Ugandan assets and ExxonMobil, which struck an agreement with Algeria’s state-owned energy company Sonatrach. There may even be opportunities for oil & gas companies to buy back their own debt at discounted prices when their cash reserves allow.
Some oil & gas companies with strong producing reserves have been able to tap investors for alternative capital solutions. For most oil & gas companies, however, securing finance from the traditional debt markets will be a stretch and they will have to pursue alternative sources of funding to see out the downturn. PE investors, direct lending funds, distressed debt funds and hedge funds could all feature and, while they are choosing investment opportunities very selectively, we are seeing some of these players step up.
Reserve-based cliff edge looms
Government financing packages—from the US Federal Reserve’s expanded Main Street Lending Program to Canada’s plans for interest-only loans as well as loan guarantees for the oil & gas industry—may also offer the sector some breathing room. But a financing cliff-edge looms in the final quarter of the year, when reserve based lending (RBL) structures (i.e. loans secured against the value of a borrower’s proved oil and gas reserves) are reviewed once again.
The value of reserves, which serves as the borrowing base for RBL debt, is assessed at biannual redeterminations which occur every spring and fall. In addition to shifts in oil prices, these assessments consider production forecasts. On both counts, markets have moved against oil & gas companies, and, when combined with the potential macroeconomic effect of future (or extended) COVID-19 lockdowns, many in the sector will find themselves with tighter liquidity restraints this fall once RBL facilities are reset.
In the spring round of borrowing base redeterminations, most borrowers saw their borrowing bases decline—in some cases as much as 50%. Centennial Resource Development reported a 42% cut to its borrowing base, with Earthstone Energy taking a 15% reduction and Chaparral Energy seeing its base curtailed from US$325 million to US$175 million.
Unless there is a significant market shift, borrowers that made it through the spring redeterminations are likely to find it even more difficult to navigate the fall redeterminations.
Banks have also revised credit agreements as part of the spring redetermination process to increase pricing on account of higher capital charges, further limit a borrower’s ability to upstream or downstream funds outside of the collateral package, and also tighten or implement anti-cash hoarding provisions, which block borrowers from drawing their facilities to the maximum and hold that money as cash. Ultra Petroleum, for example, reported that its cash hoarding sum was reduced from US$25 million to US$15 million.
While banks are either reducing or tightening their oil & gas exposures, it is not clear that they will foreclose on troubled assets given the state of the A&D market. Lenders will protect and recover value wherever possible but are unlikely to take operational responsibility for oil assets in this difficult market unless absolutely necessary. Nonetheless, there is some room for forbearance and covenant amendments for cooperative companies and sponsors in the run up to the next redetermination periods, but borrowers will still be under pressure as assessments in the second half of the year draw closer.
A light at the end of the tunnel?
In the short term, raising debt will not be any easier for oil & gas borrowers, apart from a select few oil majors and national oil companies or those with strong producing reserves that may entice non-bank investors looking to deploy capital through alternative capital solutions. The bar for any kind of new bank lending will be high. Most companies in the sector are focused on reducing costs and doing all they can to prepare for the fall reserve base redeterminations.
After a challenging first quarter, however, there are some signs of recovery. Oil prices have continued to improve following a truce between Russia and Saudi Arabia and the easing of initial COVID-19 lockdowns, which is increasing demand.
The industry remains subject to volatility and uncertainty, but there are some signs (and hopes) the worst may be over.