A version of this story appears in the November 2017 edition of Oil and Gas Investor. Subscribe to the magazine here.

It’s tough to swallow when a brighter industry outlook doesn’t materialize, whether it was expected via higher oil prices, natural gas takeaway coming online or an asset sale that would have brought in capital to fix the balance sheet.

The wave of bankruptcies and restructurings that broke through 2015 and 2016 has subsided, and experts think that deep financial distress in the E&P sector has mostly waned. According to Haynes & Boone LLP, the Houston law firm that tracks bankruptcy filings, fewer E&Ps have filed this year. As of July 31, some 14 oil and gas producers had filed for bankruptcy in 2017, representing about $5.1 billion in cumulative secured and unsecured debt, according to the firm. Since the beginning of 2015, however, the firm has tracked 128 North American oil and gas producers that have filed.

Haynes & Boone theorizes that most energy companies have already taken their medicine, having gone through a restructuring in court, a recapitalization or an out-of-court settlement. In addition, they appear to have learned to live with oil prices between $45 and $50. About a dozen have emerged as public companies. (However, distressed debt investors haven’t been able to absorb this new supply of post-bankruptcy stocks, hence low equity prices linger.)

But, some observers warn that the oil and gas industry isn’t out of the woods yet.

“Some people like to think they are one well away from greatness. None thought commodity prices would be lower for longer—for this long,” said Steve Strom, managing director of Blackhill Partners.

“The press likes to think the oil and gas industry has been fixed, but it’s not fixed, unfortunately,” said Steve Strom, managing director of Blackhill Partners LLC in New York, a specialized advisory firm that aids energy companies in distress.

“Public companies especially have had to put on a good face. They’ll say they’re drilling only the core; they’re reducing costs. … But behind the scenes in the boardroom, they’re having ‘the fear conversation’: ‘Should we borrow more money; we need to get our stock price up; we’d better sell some acreage.’"

Blackhill routinely advises E&Ps with recapitalizations and restructurings and provides partners who serve as chief restructuring officers. It recently announced a joint venture (JV) with TFA Capital Partners, a boutique investment bank serving tribal clients since 2009. The new JV will help tribes with energy financings, recapitalizations and restructuring of tribal oil and gas assets. It has been particularly active in advising some offshore-focused E&Ps such as Black Elk Energy and ATP Oil & Gas Corp., and was the first lien creditor for one Marcellus Shale operator, Trans Energy Inc., in its sale to EQT Corp. (NYSE: EQT).

Strom himself has served as an adviser in more than 100 restructurings and recapitalizations across a wide range of industries.

He joins other experts who warn that for a few E&P and service companies that have been hanging on, 2017 may yet prove to be the last straw. The Turnaround Letter has warned that although last year’s wave of energy bankruptcies has abated, a record amount of lower-quality debt raised from 2009 to 2016 is coming due, and therefore, opportunities still exist for distressed debt investors.

“Despite the industry’s new stability at this price point, a prolonged pricing trough may ultimately be too difficult for some players to bear, so additional companies may experience distress and seek bankruptcy protection in the coming months, including some that completed debt restructurings early in this downcycle,” warned Ian Peck, head of the restructuring practice group for Haynes & Boone.

For oil and gas companies, the future is still fairly uncertain as the global oil market continues to seek a rebalancing amid a real or perceived oil glut and rising U.S. production.

“Some people like to think they are one well away from greatness. None thought commodity prices would be lower for longer—for this long,” said Strom.

Reaction Time Is Critical

“One of the things we see at Blackhill, and I think lawyers and others who work on balance sheet issues do too, is that companies typically react very late. They want to wait it out, but hope is not a strategy,” Strom told Investor. “We get a lot of referrals from lawyers who tell us, ‘I’ve got someone you’d probably better talk to, meet over a meal or whatever.’ This is a leading indicator.”

Strom said he thinks we could be in a different paradigm in the future where we look back and say the summer of 2017 seems like the good old days. “A lot of people are still trying to drive their old high school Camaro and think it’ll go 90,” he said.

He describes the beginning of the process as “discouraged acknowledgment.”

This is the “aha moment” when executive management and the board finally face reality. “You hear them say, ‘Our bank redetermination is coming up in October, and the banks have been good to us so far, so we can stick it out. We’ll see.’ That kind of delayed action really limits the number of options you have.”

Blackhill educates its unique marketplace—directors and executives—on what kind of signposts they should analyze, such as, where does the company’s debt trade? “If it trades at [the wrong price], then the market is saying you may have a problem,” Strom said.

Oil and gas companies need to analyze their production streams and determine how much money they will generate, vs. the cost to maintain it. “A lot of companies cannot manage that gap,” Strom said. “Are you replacing your reserves or winding down the asset base over time? Getting through to people is challenging, but when it does get through, there is that aha moment.”

His colleague and managing director, Joe Stone, agreed. “In the early to middle part of this last downturn, for most people the aha moment would wait until there’s a liquidity issue and the banks have reduced their revolver, or the company’s cash balances start dwindling. But if you wait until liquidity becomes a problem, you’ve really limited our options to help.”

Options in the toolbox include asset sales, raising new equity, reaching out to lenders about changing loan terms, changing capex and development budgets, internal cost savings and staff reductions.

“One thing a lot of people struggle with is, they’ll say, ‘Gee, we need to raise money by selling stock, but it’s down and it would be too dilutive,’” said Strom. “Well, three months later when their stock has declined that much more, they look back and say, ‘Wow, we should have issued equity back then.’ Delaying just makes it worse.

“I’ve literally been in boardrooms where people say, ‘Should we look at this equity deal?’ and others say ‘No.’ Then six months later they look back and say, ‘Those were the good ole’ days; now we’re down to 50 cents and we’re going to be delisted.’”

If a company is not backed into a corner, but is looking to sell some acreage, that brings one set of valuations. If it is backed into a corner, the market sees that and is apt to make lower bids, which may not be sufficient to effect a successful sale.

“If the market sees you’ve done a reduction in force, they’ll wait a little longer and let you get more desperate, because then maybe buyers can get the prices down even further,” Strom said.

Balance Sheet Distortion

If an E&P company built its balance sheet based on $100 oil, but the oil price heads steadily lower, even if the company manages through it, before long the whole balance sheet has become distorted. “’Gosh, we’d never design the right hand of our balance sheet this way, yet here we are,’ they say,” said Strom.

When a company waits too long to act in the face of this dilemma, it finds itself with a lot fewer alternatives and less negotiating leverage to execute those alternatives. Especially in the optimistic oil and gas industry, where many executives have weathered commodity cycles before, they assume they can do it again.

This might no longer be true. “In the spring, people were optimistic; shale plays were great … but now there is a general feeling in the market that there’s still a supply issue, and there are a lot of DUCs [drilled but uncompleted wells] out there just ready to come online whenever the price signal is right. It’s demonstrative of the reduced power that OPEC has,” Stone said.

The U.S. oil and gas industry is becoming more akin to a manufacturing business, where the onus has shifted to cost reduction and better management. Well-run companies realized that a while ago, he said. “Now you’re seeing the amazing things technology has done, but there is still a great capital need in those plays, so you hear people say they can profitably produce at $40 oil—in order to attract investment you have to find projects that work at $40.”

If a company waits for liquidity problems to surface, it may have fewer options, advised Blackhill managing partner Joe Stone.

Strom noted that the shale business is very interest-rate-sensitive, and the rate a riskier borrower would have to pay expands as rates go up. “There’s a lot of talk about rising rates. We are working with a couple groups to raise capital ahead of any issues now,” he said.

One of the biggest issues (aside from the price of the commodity) that gets companies into trouble is if they lack an integral finance function or the right finance people, Strom said.

“You can’t have a company run just by the geologists, who can spend a lot of money,” he said. “You’ve got to fund that. So to really benefit from a restructuring process, you have to not just change the balance sheet, but there has to have been a new discipline brought to financial planning, budgeting, the finance function in getting capital, and you need to know what to do if oil prices go down by $10 per barrel. What’s your cash flow earmarked for already, that must be paid?”

Leslie Haines can be reached at lhaines@hartenergy.com.

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