Predicting when energy equity markets will be open for business is as difficult as—well, predicting energy prices. But conditions came together in the first quarter to allow some $10 billion of new equity raises, as E&Ps put a premium on financial durability in an extended downturn and underweight investors added to energy holdings designed to ride a commodity rebound.

The setting for a new round of equity raises was far from traditional. With commodity prices plumbing depths last seen in the 2008-2009 financial crisis—and equity market turbulence continuing into early 2016—E&Ps responded with steep cuts in capex and, in some cases, attempts to sell assets to improve liquidity. Sentiment regarding oil prices was “lower for longer,” even as most observers agreed sub-$30 prices were unsustainable.

“The market was set up negatively at the beginning of the year, and that has really changed a lot lately as crude has moved above $35 per barrel [bbl],” said Robert Shepardson, managing director and head of equity capital markets for energy at Morgan Stanley. But early in the quarter, he recalled, rising concern over the possible duration of the downturn was capturing the attention of E&Ps’ boards.

The issue of durability—the ability to wea­ther a protracted downturn—won out over a historical reluctance to issue equity at the bottom of the commodity cycle.

“Durability through the cycle is a key theme right now,” said Tim Perry, Credit Suisse Group’s co-head of oil and gas investment banking in the Americas. “That’s what managements and boards are saying: ‘I’ll go ahead and take the dilution.’ They’ll opt for durability even if it means dilution.”

Even for larger, traditionally better-capitalized companies, there was pressure to strengthen balance sheets. In some instances, this reflected the need to continue funding long lead-time projects, typically offshore or overseas, where operators could not lower capex as easily as they could with domestic unconventional projects. Credit ratings were important factors in determining financial flexibility.

After Moody’s adopted a more negative view on the energy sector, “certain boards focused on what they could do to preserve their credit ratings,” recalled Shepardson. “Boards were also coming to the view that, regardless of what might happen on the ratings side, they needed to take steps to help ensure that their balance sheets were fortified for the next couple of years and that their companies could weather a storm through the end of 2017 and still have good liquidity and leverage positions.”

These factors contributed to several larger-cap producers dominating early 2016 equity issuances, as opposed to the prior year’s smaller-cap issuers, said Shepardson. Notably, there were three $1 billion-plus offerings in February. Morgan Stanley was involved in equity issuances by Marathon Oil Corp., Hess Corp. and Devon Energy Corp.

Shepardson described these as largely “balance sheet-oriented financings” rather than focused on growth initiatives. On top of belt- tightening measures, such as capex cuts and noncore asset sales, these equity issuances represented an “insurance policy” designed to allay any lingering balance sheet concerns.

New issues

In terms of appetite for new equity issues, Shepardson estimated that 35% to 45% of the recent offerings were spoken for by existing shareholders. “Based on investor feedback, investors are much more focused on capital adequacy than dilution at this point,” he said. “Many investors are indicating they want to support a company and help ensure that it has the capital runway to take it through 2017 or into 2018 to help defend their investment.”

On the part of issuers, boards of directors can look to investment banks, including Morgan Stanley, to use their balance sheets to help minimize “execution uncertainty,” according to Shepardson. Instead of a lengthy roadshow, today’s marketing frequently involves a “wall cross” in which investors sign a confidentiality agreement barring them from trading in the issuer’s security for a period of time.

“As a result, there’s typically less execution risk than would be the case if you were blindly launching an overnight transaction, because a lot of this has been previewed with wall-crossed investors,” observed Shepardson.

Understandably, there is a discount to last trade when placing shares in an offering, with the discount largely dependent on the size of the offering. The discount to the prior closing trade has tended to be in a range of 6% to 9%, but bigger deals aren’t always priced at a steeper discount, according to Shepardson.

“Typically, you see a correlation there [between offering size and discount], but we have seen some large transactions where you have very high dilution but where the price impact was fairly moderate,” he said. “The offering by Marathon Oil was priced at a very tight discount of 6.8%, in spite of over 20% of outstanding shares being issued in terms of dilution.”

With many investors being underweight energy—or meeting a benchmark requirement by holding a single defensive name, such as ExxonMobil or Chevron Corp.—the issuance of equity by large-cap producers could also enable funds with significant assets under management to increase their energy exposure if their confidence grows that crude oil prices have bottomed, according to Shepardson.

Does this augur a growing optimism on the buyside at a time when producers would happily embrace measures to strengthen their balance sheets?

“Now we’ve held in this $25-$35 range for crude, I think people may get comfortable that they should start getting back up to their benchmark or overweighting the benchmark,” said Shepardson. “And in terms of being able to re-weight sector holdings, the larger funds could potentially get reasonable exposure through some of these large-cap issues.”

Entry point

Shepardson isn’t the only investment banker with a positive view of the prospects for investing in energy at today’s more opportune crude prices, which are still lower than a year ago.

“Institutions have felt it’s a great entry point,” said Credit Suisse’s Tim Perry. “Oil prices won’t continue in the $20s and $30s; natural gas prices won’t last at $2 per Mcf. Institutions have been underweight energy, and they want to invest in the ‘haves,’ that is, companies that they’re confident have sufficient liquidity to make it through the price trough and to the other side.”

Compared to 2015, when E&Ps talked of adding rigs, there has been a more constructive tone to the crude market this year as E&Ps have almost uniformly lowered capex, rig count and staffing levels, according to Perry. As an example, he cited the Baker Hughes rig count as of April 1, which showed some 362 oil rigs and 88 natural gas rigs running, down from 802 and 222 rigs, respectively, a year earlier.

“If the rig count has declined that significantly, production will inevitably decline once we work off the inventory of drilled but uncompleted [DUC] wells. That’s making a lot of investors more constructive on the commodity price outlook, which in turn makes investors feel that they’re buying in at the bottom of the commodity price curves,” said Perry.

For the better-positioned issuers that are viewed as “haves,” the stock market performance has been encouraging in the wake of equity issuance.

“An interesting point is that even with the dilution of the additional shares outstanding, the stocks of almost every single company have traded better than their peers that have not issued equity,” observed Perry. “By companies taking away the risk of added financial stress or bankruptcy, you’re seeing that those companies are consistently trading better. Investors want to invest in winners.”

As of the equity calendar in mid- to late March, Perry estimated E&P issuance by the “haves” was “probably in the sixth or seventh innings” for offerings using year-end earnings and reserve reports. Thereafter, much would depend on the direction of oil prices.

“If oil prices go down, there may not be a whole lot more, like last year,” he said. “If prices stay flat, there probably will be another round, maybe not as intensive, in the second half of the year. Some of the companies that went to the equity market this spring still have a little bit too much leverage. They may wait six months and go again.”

Bonds away

In the event that WTI recovers to $50/bbl—a scenario that Credit Suisse’s commodity analyst said could happen by May—“we may see another whole round of equity offerings,” according to Perry.

In such a scenario, he continued, the ability to issue equity would likely open up, in particular, to E&Ps whose bonds had previously fallen to distressed levels where new equity was viewed negatively, as primarily a bailout of bond investors.

“With their bonds trading at 20 cents to 40 cents on the dollar, and their equity market capitalizations diminished so much, equity investors have no assurance that these companies will make it to the other side,” said Perry. “But if oil moves up to $50, their bonds are going to start trading a lot closer to par [at $100], and equity investors will think these companies can make it and that they won’t be just throwing good money after bad. The companies that are the ‘haves’ are going to increase in number.”

And there will be no shortage of incentives for these companies to tap the equity market, if they can. “I guarantee you that we’ll be pounding the table and reminding them, ‘You had a near-death experience. If you can make it, you need to go now,” said Perry.

Even with the more well-capitalized companies, however, there is little expectation of a general rush to revive drilling programs at the expense of liquidity and balance sheet considerations, according to Perry. If E&Ps’ current hedges are set aside and an analysis is made of E&Ps’ unhedged run-rate EBITDA vs. their debt, most companies’ debt-to-EBITDA ratios remain over 3x, even after recent equity raises by the sector, he said. Historically, the sector’s debt-to-EBITDA ratio has been in a range of 2x to 3x.

“Most companies still have more leverage than they really should if oil prices were to stay flat, and I think that’s the way companies should look at it,” he said. “So a lot of these companies feel they still have some deleveraging to do, either through another round of equity, or asset sales or generating free cash flow.

“If they have that mindset, I don’t think they’ll jump too fast to add rigs and to outspend cash flow. I think people will be conservative. Let’s say oil prices do go back up to $50 or $60. I think they’re going to say, ‘I need to build up some equity; I need to build up some liquidity. I’m going to continue spending the way I’ve been spending, create some free cash flow and delever without having to go to the equity market.’ After six months to a year with oil at $50 or $60, I think they may become more comfortable.”

In addition, feedback from E&P clients on operational issues points to a process measured in months, not weeks, to increase rig activity. Bringing back rigs that have been warm or cold-stacked, plus getting crews trained and ready to work again, “doesn’t happen overnight,” said Perry. “That in itself is going to take six to 12 months.”

And with another six to 12 months needed to help rebuild a financial cushion, the combined time is likely “at least one year and probably two. And that’s once you get to $50 to $60.”

Converts preferred

In terms of issuers turning to other sources of capital than common equity, convertible preferred issues have recently regained favor in the energy sector, with convertible preferred instruments being used by both C-corp and master limited partnership (MLP) issuers.

Kinder Morgan Inc. raised $1.6 billion via a mandatory convertible preferred issue in the fourth quarter of last year, while Plains All American Pipeline LP similarly raised $1.6 billion by way of an 8% perpetual series A convertible preferred offering in January. Other issuers include Hess Corp., which in February, in tandem with a $1.12 billion common offering, raised $500 million in a series A mandatory convertible preferred stock offering.

Commenting on the Hess convertible preferred offering, Shepardson said inclusion of the convertible issue alongside the common was “a positive signal,” effectively trading a higher dividend paid to the buyer in the near term for a higher conversion price into the common—and thus less dilution—upon maturity of the instrument in three years. At pricing, the preferred had a stated conversion premium of 17.5% over the common.

However, Hess chose to use 6.5% of the proceeds to increase the effective conversion premium from 17.5% to 37.5%, using a call spread.

“The way this typically works is that the issuer is trading a higher dividend on the preferred in exchange for the ability to offset dilution three years from now,” said Shepardson. “And it allows the company to tap into a second set of investors who buy converts.”

In addition to providing a yield, the nature of a convertible issue offers investors a call option on the underlying security. For convertible investors looking at the energy sector, an evaluation may likely turn on their assessment of prospects for oil moving higher and potentially bringing up with it the underlying security. A key question: What are the prospects for crude rising above recent $30 levels in, say, three years? Those positive on the crude outlook would appreciate the upside potential.

Looking at specific basins, where has recent—and likely future—activity been concentrated? “First of all, the Permian, the Permian and the Permian,” commented Perry. “People love it. People also love the Scoop and the Stack. Other areas of good interest are Appalachia, the Eagle Ford play and the Denver-Julesburg Basin.”

As for the oilfield service sector, it “tends to be a step or two behind the E&P sector,” he said. “We need to be farther along in the cycle before we see a lot of them able to come to market.”

Asset-sale anxiety

As for prospects elsewhere in investment banking, Perry characterized the asset sale market as “slow” due to the pronounced shortage of capital and the generally low levels of confidence that asset sales can get done. For example, Credit Suisse represented WPX Energy Inc. in the sale of its Piceance Basin assets for $910 million in what he said was a “tough” deal to get done.

However, Perry anticipates that deal flow will pick up if crude prices improve. Companies still need to sell noncore assets to delever, he noted, including excess inventory E&Ps acquired during the years of the land grab. “The buyer universe will be made up largely by private equity,” as was the case in the WPX Energy asset sale, he added.

On corporate merger and acquisitions, largely absent for over a year, the sticking point remains what Perry called the “101 puts” written into most bond covenants. These mandate bonds to be redeemed at 101 (1% over par), even if the bonds’ recent trading prices have been at a steep discount. This has been a deterrent for many potential acquirers, who may face paying not only a premium over the equity value of a target, but also a premium over the recent market value accorded to the bonds.

“At 50 cents on the dollar and below, you can’t make the math work,” said Perry. “But at 80 cents and above, in an oil price recovery, I think you’ll see the return of corporate M&A. Companies will want to combine for a better market capitalization and more stability.”

With E&Ps themselves tending to conservatism in their capital allocation—and again assuming some crude price recovery—Perry also anticipates some return of drilling joint ventures. These would likely involve mezzanine and other financial players teaming up with strong E&P operators.

“Companies are going to be very conservative with their capital and look to use third-party money in JVs,” he said.

So, looking forward, opportunities may be opening on several fronts—new “haves” issuing equity, increasing asset sales, new JVs and possibly even a revival of corporate M&A—but all are dependent on greater traction in oil prices.

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