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With a more disciplined approach to preserving capital and an increased focus on core basins, some operators have shifted their efforts after emerging from bankruptcy. (Image: Hart Energy)
A version of this story appears in the February 2018 edition of Oil and Gas Investor. Subscribe to the magazine here.
It has been three years since the steep fall in crude oil prices. More than 100 North American E&Ps have filed for bankruptcy since the fall of 2014. During the past year and a half, prices have stabilized to a degree, and the general consensus concerning commodity price outlook seems to be “lower for longer.”
However, there is a silver lining for some of the restructured companies post-bankruptcy. What changes have these companies have made, and how have these changes affected their stock-price performance?
Producers analyzed are Energy XXI Gulf Coast Inc., Goodrich Petroleum Corp. (AMEX: GDP), Halcón Resources Corp. (NYSE: HK), Linn Energy Inc., Memorial Production Partners LP (now Amplify Energy Corp.), Midstates Petroleum Co. Inc. (NYSE: MPO), SandRidge Energy Inc. (NYSE: SD), Swift Energy Co. (now SilverBow Resources Inc.), Ultra Petroleum Corp. (NASDAQ: UPL) and Vanguard Natural Resources Inc.
Implementing Strategy
One initial observation is that several elected to rebrand themselves upon emergence from bankruptcy. This is arguably an irrelevant detail for a company’s performance, but it does signal a strategic change to distance the new company from the old one. These companies presumably weighed the trade-off between brand recognition vs. a potential bankruptcy stigma. Two of the 10 companies, Memorial Production Partners and Swift Energy, have rebranded themselves.
All 10 companies implemented a strategy to focus on core assets. In that regard, these have publicly announced that they will divest certain noncore assets and allocate most of their capital budget to a small number of core assets. Half have fully exited from one or more basins. These operators have successfully divested assets in an environment with variable bid/ask spreads.
There can be multiple reasons for a company’s decision to exit certain basins, including focusing on high-grading areas with the highest potential return on investment. Another rationale can be the popularity and premium valuation associated with pure-play operators that allow investors to select their desired exposures and diversify accordingly. As the shale boom and associated basins matured, investors have developed stronger opinions about risk-and-return profiles of various North American basins.
Also, in a lower commodity price environment, investors are seeking more targeted investments with Permian Basin or Marcellus Shale exposure, rather than a general oil or gas focus. There was an interesting parallel several years ago, although under a different set of motivations, when vertically integrated companies split to realize a higher total valuation for the sum of the parts. Recent examples of those spin-offs are those of Marathon Oil Corp. (NYSE: MRO) and ConocoPhillips Co. (NYSE: COP), which spun off their downstream assets, and the long list of operators who have dropped down their midstream assets into MLPs.
With a more disciplined approach to preserve capital and an increased focus on core basins, operators have shifted their efforts from proving up acreage to a methodical approach of optimizing barrels per invested dollar—stated differently, shifting from exploration to development. All 10 have designed cheaper wells with longer horizontals and increased proppant loads.
Early in the shale boom, many producers were testing new technologies and completion methodologies. This high-tech appetite has generally dried up and operators have moved to more commoditized, but proven, technologies. In this challenging environment, operators are forcing their oilfield service providers to fiercely compete for the lowest price point and, as a result, are drilling cheaper wells.
In addition to the trend toward commoditized technology solutions, excess service capacity has proven to be a windfall for operators. Along with the cheaper wells, E&P companies have generally concluded that there are superior returns from each additional foot drilled, decreased stage and cluster spacing, and incremental ton of proppant pumped. This new industry paradigm has resulted in bigger and longer wells that are producing more hydrocarbons for less money.
Throughout E&P bankruptcies, stakeholders have successfully argued the importance of retaining key employees and have awarded executives and employees with periodic bonuses. Upon emergence from bankruptcy, management and key employees often have the opportunity to earn a percentage of the emerged company’s equity in order to align their incentives with the company’s. Although this percentage varies from company to company, the percentage earmarked for management is frequently around 10%. The retention of the same management team pre- and post-emergence is not as uniform as some of the other trends we observed with four of the ten E&P companies replacing management.
Structuring Capital
Another trend that is pervasive among E&P companies that emerged from bankruptcy is subsequent changes to their capital structure, often equitizing subordinated or second lien debt. This is not surprising since most of the E&P bankruptcies were necessitated by a high degree of financial leverage.
Upon emerging from bankruptcy, the E&P companies’ debt, often only secured first lien debt, was held by the pre-petition lenders (usually banks). The banks and E&P companies both made concessions in terms of covenant and reserve-based lending redetermination holidays, and a combination of conforming and non-conforming tranches of debt. Either the E&P company, the post-petition lender, or both desired a different capital solution. The reasons behind the desired changes may have differed from company to company, and we can only speculate what the actual reasons were. E&P companies may have been looking for lightened covenants, more flexibility, or a lower cost of capital. Banks, on the other hand, were likely seeking additional protection in order to operate within the new guidelines from the Office of the Comptroller of the Currency. Additionally, in several E&P bankruptcies the company and its lenders were at odds and testified against each other to protect their own interests. Defensive draws made by E&P companies shortly before filing for bankruptcy protection are often points of contention and can strain the relationship between the parties prior to the start of negotiations.
To improve capital efficiency or finalize a restructuring agreement, some of the selected companies offered non-traditional solutions. For example, Linn Energy spun off its previously acquired business, Berry Petroleum Co. LLC, which primarily operates in California. Berry had a different group of bond-holders with their own set of objectives, which impeded Linn’s plan of reorganization. Vanguard also changed its corporate structure from an upstream MLP, which is required to distribute cash flow to shareholders, to a more flexible C-corp structure.
SandRidge entered a drilling agreement—a Drillco—in which investors fund the capex for new wells and receive a reversionary working interest with a carry on the back end. This off-balance-sheet financing technique has been popular as investors seek asset-level deals, and operators are permitted to continue their development projects with minimal initial capital outlay.
In the ongoing bankruptcy proceedings of Breitburn Energy Partners LP, management has leveraged its attractive Permian assets for a direct investment opportunity through a rights offering to alleviate some immediate funding needs. Even though these three transactions are fundamentally different in nature, each represents a creative way to attract investor interest and facilitate a transaction.
Although details are often private, several of the E&Ps have publicly discussed their midstream-contract revisions. Legacy offtake agreements can hinder the companies if consuming a substantial portion of the new, lower wellhead economics.
A way to reject or restructure these agreements has been in bankruptcy court, where the debtor has more negotiating leverage. E&Ps have restructured some of these contracts simply by negotiating lower rates or volumes, while others have taken a commodity price-indexed approach, and some have fully rejected the agreement.
Ultra Petroleum rejected major midstream contracts during its bankruptcy proceedings. Ultra’s management highlighted that it did not need to engage in firm offtake agreements due to excess pipeline capacity in its markets.
Impact To Share Price
It is interesting to compare the operational and financial changes with the post-emergence stock-price performance of the various companies. Oil prices have generally stabilized during the past 18 months. Gas prices are more cyclical in nature and have been within a range of $2.50 to $3.50 per thousand cubic feet with more seasonal fluctuations. The stock prices for each of the emerged E&Ps with the SPDR Index Oil & Gas Exploration & Production ETF demonstrated generally similar performances with a few exceptions. Linn is the standout performer while Energy XXI is the clear laggard, with the rest of the group trending near, but slightly below, the index.
Linn has demonstrated significant changes from an operational and financial perspective. It is optimizing performance by successfully divesting noncore assets, entering a joint venture to reduce capital intensity and announcing an equity share buyback. Linn took a step further and announced that the company will split into three separate businesses, one focusing on its core Oklahoma assets, another with the midstream components in the core area, and another public entity with the remaining assets. This split allows for a tailored investment strategy based on an investor’s desired exposures.
Energy XXI, on the other hand, is underperforming due to its offshore exposure and associated rigid cost structure rather than any company-specific initiatives. Additionally, Gulf of Mexico assets are difficult to divest with a limited set of buyers, due to the complex infrastructure required for offshore assets and the associated capital-intensive requirements of operating offshore.
Even though there are some timing differences of when the various parties filed for and emerged from bankruptcy, the remaining group has traded about 15% below the index. The drivers behind this performance may include the fact that the ETF index includes higher-quality assets of companies that never filed for bankruptcy. Generally speaking, while oil prices have stabilized during the past 18 months, the emerged E&P companies’ stocks have underperformed in comparison with oil prices, signaling a potential divergence in conventional wisdom that E&P stock prices are heavily correlated with commodity prices.
While it is difficult to explain every reason behind the relative performance, some of this underperformance could be attributed to the burgeoning investor fatigue in the marketplace.
A popular concept that has risen with unconventional resources is the breakeven price. Even though this term is routinely mentioned, it is probably not consistently defined amongst investors and even some industry participants. Oftentimes when E&Ps refer to breakeven prices, they only refer to the marginal returns from an incremental oil and gas well. The breakeven price frequently does not include all of the associated costs for infrastructure, leasing, geological and geophysical exploration, lease bonuses, corporate general, and administrative and full-cycle costs. These supplementary costs are considered sunk costs and therefore should not be considered for the decision of drilling an incremental oil and gas well.
Even if the industry was fully aligned with the exact methodology for this type of analysis, it is not an auditable metric to track. Operators who are even slightly promotional can change some of the underlying assumptions to materially improve some of these performance metrics. Many of the shale operators have publically stated that they can be cash flow positive with crude prices in the $40s or $50s, which is substantially lower than it was a few years ago. These current price levels have now led to a more “show me” story as it can be difficult for investors to determine which companies are embellishing portfolio quality and which companies really do have better prospects.
Throughout the upcycle, operators were praised for raising production or acquiring acreage in a desirable basin. Admittedly, this type of compensation structure is justifiable with $100-per-barrel oil prices, but it has not materially been amended to reflect the new price environment. For an E&P company with acreage and drilling prospects that offer returns in excess of their cost of capital, it is logical to outspend operating cash flows. With the cost of debt at historically suppressed levels and an appetite for yield, investors flooded shale companies with cheap debt enabling companies to over-lever. Even though the industry has had difficulty defining profitability metrics that make sense, financial returns were rarely an operating metric for executive compensation. Recently, a group of investors assembled and urged management of certain E&P firms to focus on profits and shareholder return rather than operating growth.
E&P companies have had a challenging couple of years and are now focusing on core operations more than ever with cost reductions, capital discipline and a focus on development plans facilitating their recovery. Even though the stock performance of individual E&Ps moves in conjunction with macroeconomic factors—i.e. supply and demand of oil and natural gas), company-specific fluctuations due to unique assets, strategic initiatives and management also have the ability to dramatically create value.
- Paul F. Jansen is a managing director in Conway MacKenzie’s energy practice. He performs strategic, financial and operational analyses to unlock value in challenging situations. He has extensive experience serving as executive management to both publicly traded and privately held energy companies. Jansen is a certified insolvency and restructuring advisor, certified public accountant, accredited in business valuation and a chartered accountant in the Netherlands.
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