At press time, as crude oil prices fell to 11-year lows, the Nymex strip predicted WTI will stay below $45/bbl for much longer, and distress spread from the dry plains of West Texas to the steel canyons of Wall Street. No wonder executives and investors alike are taking a deep breath and looking around. What are the various options in front of them, and how do these rank in efficacy?

The industry responded swiftly, first in the field by cutting costs and drilling activity. A recent report from Seaport Global Securities said the firm expects capital efficiency to remain the foremost guiding principle for E&Ps in 2016, “likely yielding further talk of D&C cost savings and efficiency gains ahead.”

Everyone is singing the same tune now: Spending must be aligned with lower cash flows. Even a company as robust as EOG Resources Inc. reduced its Eagle Ford rig count from 50 to 15 by year-end 2015. Outspending to achieve production growth is definitely not in the cards. What’s in favor? Prudent, reduced spending in the field, less overhead at the office and reduced or postponed debt obligations.

Variable field costs have been cut dramatically, but the law of diminishing returns has now set in; further reductions in drilling and completion costs will be smaller and much harder to achieve in 2016 (if possible at all). At some point, these lower service costs will impair the industry’s ability to drill and service a well safely while meeting a service company’s overhead, much less its ability to continue any R&D, training and retention of employees.

Beleaguered CEOs do not want to see the disintegration of the service industry, but that sector will struggle this year when U.S. upstream capex is predicted to fall another 20% to 25% on top of the 25% it declined last year.

Meanwhile, in order to endure, E&P companies are paring or omitting the dividend, selling noncore assets, laying off employees and postponing projects. Eclipse Resources Corp. announced it will not field any rigs this year on its Marcellus position. Whether that helps the company survive or merely postpones the need to take other drastic measures remains to be seen. After all, Magnum Hunter Resources Corp. dropped all its rigs in the Marcellus and Utica in first-quarter 2015 and sold assets as well, yet by December it had to file Chapter 11 anyway.

Indeed, energy law firm Haynes & Boone tallied 38 producers that filed for bankruptcy in 2015, owing more than $14 billion, with the latest, Magnum Hunter Resources and Swift Energy Co., doing so in December.

Companies need to manage decline rates and plan for below-strip pricing, said Guggenheim Securities E&P analyst Subash Chandra.

Warnings

More trouble for the sector lies ahead, and the debt rating agencies have been sounding the alarm. At press time, Fitch Ratings said the trailing 12-month high-yield bond default rate in energy, as of December, was 7.2%, and it expects the default rate to increase to 11% this year.

Moody’s Investors Service said some 29 producers were under review for possible rating downgrades. The company said it will even review such stalwarts as ConocoPhillips, Anadarko Petroleum Corp. and Newfield Exploration Co., none of which are in financial trouble.

Yields on speculative or junk bonds in the energy sector have risen to nearly 15%, the highest since the crisis in 2009, the last dramatic industry downturn, he said. Meanwhile, Standard & Poor’s reported that the distress ratio in energy was up to 20% in November, the highest ratio seen since 2009.

The E&P sector has seen a surge in distressed debt exchanges, Moody’s said, where creditors agree to take smaller amounts of secured debt, with second or third liens, in exchange for the senior unsecured debt they had held. Creditors thus hope to improve their priority for repayment in the event of a default or a bankruptcy.

“Two-thirds of the defaults in the U.S. oil and gas sector in 2015 were distressed exchanges where unsecured debt below a reserve-based loan facility was affected,” Moody’s said.

Standard & Poor’s Global Fixed Income Research said that in 2015, the oil and gas sector led the all-industries default tally with 29 defaulters, or 26% of the global total. More than a third were due to distressed debt exchanges and another third was due to missed principal and interest payments.

Bad things do happen

The strongest correlation to stock performance in 2015 was the health of a company’s balance sheet, and that is likely to be the case in first-half 2016 as well, according to Guggenheim Securities E&P analyst Subash Chandra.

“The big picture, in our view, is that the leveraged growth phase retreated to cash-flow neutrality in 2015, but that is an interim step toward de-levering the group over the next few years,” he told Investor. He added these bits of advice.

“Companies need to take a conservative, possibly below-strip view of commodity prices and budget accordingly. Don’t outspend, at the very least, but prepare to repay debt, if bank debt has not been repaid already.

“The easiest way to de-lever is raise equity, no matter how painful it is. Companies that have managed well in 2015 raised equity even if it didn’t look like they needed it, Newfield for example.

“Operationally, drop rigs in all noncore areas, monetize the assets, if possible. Focus on decline rate management. This may shift the expenses from capex to opex, but will have a more certain and near-term payoff (re-fracks, lift systems, compression, etc.).”

Bankruptcy is always the last resort, often buying time to negotiate further with creditors and bondholders. But the poor financial conditions often unmask other problems.

“If you look at the earliest filers, they all have one of three things in common: bad management, a bad capital structure and bad rocks. You can fix the first two, but not the third,” said Mike McMahon, managing director and co-founder of private equity provider Pinebrook.

Speaking at the Privcap Media Energy Game Change Conference in Houston in December, he said, “Not everyone is in the core of the core of a play—not everyone is a Scott Sheffield, the luckiest man alive.” He is CEO of Pioneer Natural Resources, one of the largest acreage-holders in the sweet spots of the prolific Permian Basin.

“For private equity players who support so many companies, candidly, we can’t just sit there and let the meter run,” McMahon said. “We can solve the capital structure but not the rocks … and when the slow followers entered the [shale land grab] game late and had to pay upwards of $30,000 an acre, you then saw low returns even if you had good rocks.”

McMahon said he now wonders if people are sitting on Tier 3 rock and “deluding themselves” that they own Tier 1 or 2. How much money will they have to spend (waste) drilling enough wells to find out the true quality of their acreage?

WL Ross & Co. has made distressed investing a key strategy since its founding in 2000. “Bad things sometimes happen to good companies across the business cycle,” said Shaia Hosseinzadeh, managing director and head of natural resources and energy, who spoke at the Privcap event. With approximately $8 billion under management across private equity, credit, infrastructure and mortgage funds, WL Ross is one of the world’s leading turnaround groups. It invests in and restructures financially distressed companies in several industries, including energy.

“We estimate two-thirds of the E&P industry does not have a viable funding model at $38/bbl. Now that does not mean they will all go bankrupt,” he said, but in coming months a lot of financial restructuring will be announced.

“Good management teams are figuring out a way to do more with less capital,” he said of the experienced management teams who have been through energy downcycles before. They took action early, with the collapse of the U.S. rig count the most glaring evidence.

That action continues. For example, Southwestern Energy Co. said it will drop all rigs in the Fayetteville Shale in the first quarter, focusing only on the Marcellus. That’s a sea change for the company that discovered the Fayetteville, produces 2 Bcf/d there, and claimed last year to have 5,000 locations if gas was $4/Mcf.

On the front lines

The chief restructuring officers embedded within consulting firms are the generals on the front lines today, helping distressed E&Ps all over the oil patch. When a company is imperiled, the first step is to acknowledge it, and then make an inventory of whatever strengths can be used to push through a financial or asset restructuring. Shots are being fired from all sides: bondholders, banks and trade creditors are calling, shareholders are nervous, the board and staff may be overwhelmed. Restructuring is usually required and is but the first step in what could be a long process.

Capitulation may be too strong a word, but, “when we are called in, there is often an acknowledgement that a problem exists and the board of directors and management want assistance in solving it,” said Seth Bullock, managing director with Alvarez & Marsal.

“In many cases the problems are obvious, but sometimes they can be more subtle,” he said. “The largest challenge in restructuring is in developing a plan that the multitude of stakeholders, financial advisors and lawyers can agree to. There are a lot of smart people with their own agendas at the table, and it takes time to navigate the process.”

Liquidity is the key, he said. “Every company is different, but generally we take a hard look at the drilling program. Wells that are attractive on an IRR basis can be liquidity-damaging in the short term. For example, a well that generates a 30% IRR is a good well, but it can take up to two years to get your money back. In a liquidity-focused environment, we generally focus on projects that have a six-month payback period or less. The goal is to extend the liquidity runway.”

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