E&P Financing Case Study: War Bonds

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

In late February, the Pioneer Natural Resources Co. team wrapped the year-end earnings call and was filing the 10-K while readying to refinance senior notes due 2021 and 2022.

In January, it had paid off its $450 million of 7.5% senior notes due this year, using cash on hand.

It had an undrawn $1.5 billion bank revolver. The 2021 maturing notes totaled $500 million. After that, it had $600 million maturing in 2022; $500 million in 2026; and $250 million in 2028.

Cash on hand was $631 million.

It was now Friday, Feb. 21. “We had our 10-K ready to be filed, along with a new bond offering ready to go—five- and 10-year bonds,” said Rich Dealy, president and COO.

The 10-K was filed on Monday. The bond offerings wouldn’t happen, though.

On Monday, “that’s when the rug was pulled out from under everybody,” Dealy said “All of a sudden, the impact of COVID-19 hit the capital markets, with the stock market falling, Treasury rates skyrocketing and credit spreads widening.
“On top of that, Saudi Arabia and Russia were starting to get into a price war.”

By the end of the following week, it became clear that Saudi Arabia and Russia wouldn’t agree on the production cuts necessitated by reduced oil demand as the virus spread across the globe.

When Pioneer had wrapped its earnings call on Feb. 20, the prompt-month (April delivery) WTI contract on Nymex was about $53. On March 5, it closed at $46.

At the end of the March 9 trading session, it was $31.

The refinancing was postponed, Dealy said. Until when? No one could be sure.

“The financial market just wasn’t going to do a transaction. And, as we went through March, things were getting worse.”
Should Pioneer do a short-term bank loan? It didn’t need one. It had more than $600 million of cash on hand.
But should it, just in case? Yes, the board agreed.

“We went to our bank group and put in a 364-day unsecured credit facility just to have incremental liquidity. It was insurance against an extended low-oil-price environment and the potential for a long-term supply glut if the Saudi/Russia price war continued.”

Getting in line

Pioneer wasn’t alone; there was a line. “I mean, everybody,” Dealy said. “It was probably one of the hardest deals [I’ve done] because banks were getting approached by not only energy companies but by just about every industry.”

You name it. “Airlines, cruise lines, manufacturing, tech were all trying to shore up their balance sheets too. So banks were just getting inundated with liquidity requests.”

Dealy got in the queue. With so many requests, bankers “were stingy about who they would deal with.”

He was on the phone “it seemed like five days solid, just talking to banks, trying to get that credit facility put in place.”

Pioneer got it done on April 3 for $905 million. “It was going to be a one-year facility. With so much going on, we wanted to make sure we had plenty of firepower to withstand a potentially tough year if things didn’t open back up.”
It only got worse, though. At the end of the April 20 trading session, next-month delivery of WTI closed at a negative $37.63.

After Pioneer’s February earnings release, Mark Lear, senior research analyst for Simmons Energy, had written, “Raising the Bar: Big FCF Beat Complements Solid FY20 Outlook.”

On March 25, though, he titled his report “Downgrading Seven E&Ps; Shale Will Survive but Uncertain Path Lies Ahead.” He pared Pioneer and six other large independents to Neutral.

“We think we have yet to witness the worst of the current oil-market turmoil play out in the physical markets, which we expect to see in the coming months,” he wrote. That came April 20.

0.25% money

Another option developed for Pioneer: Do a convertible senior note. “When we got toward the end of April, things started stabilizing,” Dealy said. “You could tell the financial market was improving and the bond market was reopening, albeit at much higher rates.”

In May, something remarkable happened: A door opened. “We had this opportunity to issue a low-coupon convertible bond.”
Pioneer had done one of these in the early 2000s, when it and most of the U.S. E&P industry was making oil and gas from conventional rocks from vertical wells.

What it wasn’t expecting in May was such a low interest rate: 0.25%. “In February, we were looking at issuing 10-year notes around 3% or so. In May, it would have cost 4%-plus.”

This convertible senior note would cost 0.25% instead.

Pioneer had cash on hand, $700 million still undrawn on its bank revolver and an undrawn 364-day $905 million line of credit.

But five-year 0.25% money was an offer not to be refused. “The upside for our investors is it significantly reduced our cash interest cost. We tendered for our higher-cost near-term bonds and replaced them with 0.25% bonds.”

It added a feature—a capped call—to effectively limit any share dilution as its stock price increases. With this, “We won’t have to issue any more shares or come out of pocket with incremental cash unless [the] price goes above $156 per share,” Dealy said.

At the time, Pioneer shares were trading in the low $80s, “so it made a ton of sense to reduce our overall financing cost as a company.”

‘Never dreamed’

Meanwhile, the low-cost money further freed up cash flow. “All of these steps we’ve taken [over the years] have been about improving free cash flow.”

Borrowing 0.25% money (due 2025) and paying off 3% and 4% money (due 2021 and 2022) “was a tremendous cash-flow savings,” all going toward generating more free cash flow.

“I would have never dreamed,” Dealy said of the opportunity.
But it was true. The week of May 11, Pioneer sold $1.3 billion of 0.25% convertible notes due 2025 with interest payable on May 15 and Nov. 15 each year.

It used $113 million to pay for the base capped-call protection; bought back $50 million of shares; and retired $360 million of 3.45% senior notes due 2021, $356 million of the 3.95% notes due 2022, and $9 million of 7.2% notes due 2028.

And it canceled that 364-day credit facility.

The notes are convertible to PXD shares if they reach $156.21 before mid-May 2025—an 85% premium over the share price of $84.44 when the deal closed on May 11.

Simmons’ Lear wrote, “Pioneer demonstrated the capital markets are not only open—for some—but the cost of capital is very attractive.”

He estimated the transaction saved $15 million of debt-service cost a year.

1.9% money

Pioneer was set for at least another half-decade. But another opportunity came along.

Issuing new 10-year notes is what it had wanted to do in the first place—back in February. In August, that window reopened. And at 1.9%.

Pioneer offered $1.1 billion of 1.9% senior notes due 2030, priced at 99.205%.

“Our August transaction was really just opportunistic,” Dealy said. “We didn’t have to do anything in August.”

But it was 10-year money for less than 2% a year—“something I never dreamed Pioneer would ever be able to accomplish. I think we’ll never regret having gone out there and raised 10-year money at 1.9%.”

Again, it had to move quickly. “One of the things we have learned as a company is that, when the market is there for a transaction that you’re willing to do, then push really hard to get it done because you never know—markets can change quickly.”

Of the August opportunity at 1.9%, Dealy said, “We knew it would be fleeting. Literally the week after we got it done, rates started moving up. We probably would have been 10 to 20 basis points higher had we waited over a weekend.

“Being prepared and being willing to push to get things done pays dividends when you’re ready to transact at those levels.”
Pioneer put the net proceeds of about $1.08 billion on its balance sheet. It’s there to pay off the rest of the 2021 and 2022 bonds that weren’t tendered. And it’s there to pay off a portion of the 2025 bonds.

“From those two transactions—the 0.25% convertible and the 1.9% notes due 2030—we’ve reduced our cash interest cost by 2%-plus. It’s incremental free cash flow year over year and lowers the overall borrowing cost of the company.”
Pioneer’s net debt to book capitalization at June 30 was 15%. Pro forma for the August transaction, cash on hand as of June 30 totaled $1.3 billion.

Gabriele Sorbara, senior equity analyst for Siebert Williams Shank & Co. LLC, had downgraded Pioneer to Hold on June 9, stating that the stock’s price was higher than the company’s asset valuation at oil prices at the time.

“We believe the recent stock price moves have been driven by passive/retail buying, quants and short covering, which have significantly elevated speculation/risks,” he wrote.

On Aug. 13, though, Sorbara announced that “We are back on board with a Buy rating.” His price target was $147.

“We believe PXD shares justify a large premium for the new framework, which should drive consensus estimates higher and further share outperformance.”

‘Too untenable’

Pioneer had been steering toward free cash flow and a low debt profile for years, said Dealy, who joined the company in 1992 when it was Parker & Parsley Petroleum Co.

It’s resulted in a strong balance sheet and low debt-service cost. This year in particular, the conservative balance sheet paid off.

“As an industry, the vast majority of public E&Ps have too much leverage because they were borrowing money to grow. So, you’ve seen a number of companies declare bankruptcy,” Dealy said.

Like Pioneer, many went to banks and bond markets this spring. “But they weren’t issuing bonds at 25 basis points or 1.9%. They were issuing bonds at six, seven, eight, 9% interest.

“They were forced to just accept that because of their credit quality.”

He concedes Pioneer hasn’t “always had the balance sheet that we have today.” Earlier in his career, the company was overlevered. “We had bonds that were seven, eight and 9%.

“And that was just too untenable to me—in this industry, being in the commodity-price environment. So, we worked hard over the last 10 to 15 years to really bring leverage down.”

E&P investors have seen debtholders become the shareholders post-bankruptcy “and the equity-holders basically walked away with nothing.” Investors won’t stand for it any longer.

“You really see investors promoting companies to lower their leverage, have a strong balance sheet and return more cash to shareholders.”

As the E&P business is now, “If you want capital, you need to start improving your balance sheets and, hopefully, lower the cost of your bonds in the future.”

‘No risk’

Pioneer’s position is to generate cash flow that can pay off its debt in less than one year, if need. At the current rate, it could pay it off in nine months.

Fundamental to Pioneer’s ability to improve its financial profile—despite 2020—is its assets, Dealy said. The company’s wells generate some of the highest rates of return in all of the Midland Basin, he said.

That’s based on J.P. Morgan Securities LLC analyst Arun Jayaram’s analysis in late September. Jayaram found that Pioneer’s 12-month cumulative production per well was 25.1 boe per lateral foot (boe/ft) in 2018 and 25.9 boe/ft in 2019. Jayaram concluded that, “When comparing Pioneer’s productivity with peers in the Midland Basin, … Pioneer delivered the highest well productivity in 2018 and 2019.”
Meanwhile, Pioneer’s drilling, completion and facilities costs have been pared, Dealy said. On G&A, that’s lower now as a result of a 2019 reorganization and executive pay cuts.

As oil prices began to collapse, Pioneer cut its 2020 capex plan of up to $3.5 billion to top off at $1.6 billion.

“We were able to do these debt transactions from a position of strength,” Dealy said. “There was no bankruptcy risk, no risk of not getting repaid.

“So, fortunately, we were able to tap the markets at opportune times during the year to prepare well for the future.”

Jayaram wrote in early September that, even at $40/bbl WTI into 2025, Pioneer should be able to generate a return to shareholders of $17 per share. If $50/bbl, then more than $40 per share.

He reiterated his Overweight rating on the stock.

‘At the bottom’

Dealy doesn’t see another capital transaction in the near future. “We’re well set up now. We really don’t have any refinancing needs until four or five years from now—if then.”

What debt it has, using its model of reinvesting up to 80% of cash flow and using the balance to pay base and variable dividends and to reduce debt, “We may be able to pay [the bonds] off with cash, given the cash that’s sitting on the balance sheet.”

The next maturity—the $1.15 billion of 0.25% convertible notes—isn’t until mid-2025.

“You never know what your interest rates are going to be in the future, but I feel like we’ve executed near the bottom,” Dealy said.

“It seems like rates can’t get much lower. There is more probability that they’re going to go up versus down.”

But one never knows what a new year will bring. 2020 had Pioneer’s teams dispersed, working from home. For a time, all of Pioneer’s transactions were done by personnel working off-site. Many remained off-site in early October.

“We’ve been very lucky that we’ve not really missed a beat by having people work at home,” Dealy said.

Of course, by September, employees were becoming weary of meeting via virtual platforms, he added. But the trade-off has been worth it: Everyone’s been safe.

“I suspect we’ll all look back at this year and say, ‘What a strange year that we will remember forever.’ In every scenario-planning and risk-planning, this is one you never thought of.”