Right-sizing G&A for the New E&P Reality

[Editor's note: A version of this story appears in the September 2020 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

Dealing with market volatility and uncertainty, negative investor sentiment and depressed stock valuations isn’t new to the upstream oil and gas industry, but today is different. The recent oil price rout has surpassed similar downcycles seen in the mid-1980s and 2014 to 2016 thanks to the one-two punch of coronavirus-related energy demand destruction and the collapse of the OPEC+ supply-management effort that, for more than three years, had propped up crude oil prices. In response, many E&Ps slashed their 2020 capital spending plans and have touted how much of their 2020 production levels are hedged.

The new reality is that most of the industry is in an asset preservation or “blowdown” business model: a focus on cost reduction and maintaining existing profitable production over converting undeveloped locations; reduced rig counts; shutting in higher cost wells; limited storage capacity; and little to no discretionary spending. Reducing G&A to align with this new reality is now more important than ever.

G&A costs: In focus

The days of growth (and debt) at all costs to maximize shareholder returns through an asset sale or IPO are now giving way to a focus on free cash flow. Historically, E&P cost structures increased dramatically as companies quickly added people and overhead to match the scale of current or expected operations. Companies like EOG Resources Inc. and Hilcorp Energy Co. are often lauded for the quality of their assets; however, competing management teams and boards may have lost sight of the fact that those companies also operate under a culture of running lean—they employ proportionately fewer people compared to their peers and align compensation to reward results.

For the year ended Dec. 31, 2019, EOG’s G&A was 3% of its annual revenue, compared to the average and median percentage across all exchange-traded upstream companies of 25% and 10%, respectively.

An independent Opportune LLP study identified that G&A across all exchange-traded E&Ps increased 14% from 2018 to 2019, while their revenue declined 4% during the same period. In 2020, the situation is clearly worsening, and many distressed public companies are starting to shed G&A via reductions in headcount and benefits. For example, another recent Opportune study of Form 8-Ks filed through May 2020 identified that about 15 public companies have announced specific cuts in executive compensation ranging from 10% to 20%.

The new reality

In the current environment, E&Ps should be optimizing production, lowering LOE and G&A and finding sustainable cost savings such as taking out layers of management or closing regional offices. Cuts to back-office accounting, IT, land administration and/or asset development departments are inevitable to better reflect the current environment.

The pertinent questions to current management are two-fold:

1. Have they accepted this new reality, and are they capable of cutting costs in a meaningful way?
2. Are they committed to aligning the company’s goals to that of their current (or new) owners?
3. Ready, willing and able?

Capability vs. willingness may be semantics, but we’ve found that a management team’s background (it’s not just the CFO—change takes commitment from the entire C-suite) may determine their ability to succeed in this new environment.

Management teams that grew up in large public companies or transitioned to such entities after careers in banking, public accounting or other sectors outside of oil and gas often don’t know any other way than what they’ve historically seen. Even under a blowdown business model, these executives consider large investor relations and human resources departments, maintaining a full back-office to continue managing antiquated accounting systems and keeping geology, drilling, completion and land departments intact a necessity. “We have to be ready for the rebound,” they say.

Management teams that entered the C-suite by starting private-equity portfolio companies during the 2009 to 2014 boom years may potentially yield the same results. While some of these entities often begin lean, start-up portfolio companies by nature must be ready for sudden and rapid growth and often elect to preemptively hire a number of people across several functions rather than outsource until they reach a steady state. Fast forward to today, having missed the opportunity to monetize, these companies are now left with a headcount and associated G&A that’s excessive when considering a blowdown business model. “But we don’t need to cut G&A—we’ve always run lean,” they say.

Representative entities may be ready for the rebound, but you (the C-suite) probably won’t be around to see it, as public companies are filing Chapter 11 and private-equity portfolio companies are being smashed together at a record pace. What was considered lean under an asset development model is likely bloated under a blowdown business model aimed at managing existing production to maximize free cash flow and pay down debt.

Committed to maximizing free cash flow?

Whether companies’ performance incen­tives have historically been aligned to investor needs is debatable, but we’re playing a whole new ballgame today. The field of play and goal posts have changed. Gone are the days of real estate speculation where the primary goal was to acquire acreage (at any price), drill a few wells to prove up the field and then flip the asset package or company for a pot of gold at the end of the contango rainbow.

Today’s game is about maximizing cash flow to pay down debt and returning cash to investors. The A&D market is almost nonex­istent, and no value is being given for proved undeveloped reserves (PUD) or unevaluat­ed acreage. Even Chesapeake Energy Corp., which had skirted bankruptcy for a decade through asset divestitures, finally succumbed to the inevitable on June 28. Companies emerging from Chapter 11 and those hoping to avoid it must have a viable plan that gener­ates free cash flow. Period.

A recent Kimmeridge whitepaper theoriz­es that an E&P trading at 3x EBITDA of $1 billion could generate a 9% yield to investors by reducing G&A by some 12% and reducing capex to approximately 75% of current year EBITDA. The whitepaper provides examples of two companies in the refining (Valero En­ergy Corp.) and tobacco (Altria Group Inc.) industries that have effectively generated such returns using similar G&A- and capex-reduc­tion initiatives through years of volume, price and social pressures.

Kimmeridge stated, “We believe that by mak­ing these changes and following the same play­book, the E&P industry could reduce the risk of equity ownership for investors with visibili­ty toward 100% of capital returned in a decade with a retained option on the asset base should energy demand continue to grow.”

Right-sizing—a comprehensive approach

Right-sizing is a term that was first thrust into the mainstream by manufacturers and businesses of all sizes and industries during the 2007 to 2008 financial crisis. This princi­ple applies to the upstream oil and gas industry today. E&Ps should consider implementing a comprehensive approach to right-sizing their organizational structure that better reflects the current market climate and aligns with compa­ny goals/objectives.

A comprehensive approach should start with a bottoms-up analysis to identify every department and employee position that’s es­sential if, based on the current business model and environment, the company was starting up today. Positions not deemed essential should be eliminated immediately. For each current employee in an identified essential position, three questions should be considered:

1. Would you hire that person again?
2. What base salary would you pay them?
3. How would you incentivize them?

If the market turns around and expansion is needed in the future, quality employees can always be hired at the right price. Executive compensation packages should be predicated on capital preservation and returning cash to creditors and owners. Plans that tie perfor­mance to bonuses and/or incentive awards should also be rationalized and be based on current company goals and objectives. Person­nel decisions are probably the hardest activity any leader performs and often involve uncom­fortable conversations with friends, mentors and mentees; however, good people always find good work, and those employees may de­serve a fresh start as much as their former em­ployer’s balance sheet.

Additionally, a top-down analysis of each G&A category and material contract therein should be performed to identify cost-cutting le­vers resulting from reduced personnel and busi­ness activities.

Josh Sherman is the partner in charge of the Corporate Finance and Complex Financial Reporting groups of Opportune LLP. Josh has 20 years of experience in advising financial and accounting executives on the formation, support and analysis of their teams. Josh is currently an independent board member of U.S. Energy Development Corp., and previ­ously served on the board of directors as au­dit committee chairman of JP Energy, Trans Energy and Voyager Oil & Gas.

Petar Tomov is a manager in Opportune LLP’s Valuation practice and is one of the firm’s leading experts on employee and exec­utive compensation matters. Combined with his time as a manager at KPMG, Petar has nearly 10 years of experience focusing on the valuation of stock-based compensation, complex securities and intangible assets for financial and income tax reporting.