There is a lot of chatter around the water cooler about how falling energy prices puts energy companies and service companies into distress, and—importantly for private equity investors with liquidity—provides an opportunity to acquire energy assets at distressed prices. This article provides a very basic hypothetical to help laymen understand how falling energy prices can lead an energy company to a restructuring, and, potentially, sell its assets at distressed prices.
Exploration & Production Company (“E&P Co.”)
Assume E&P Co. leases minerals in several geographical locations, and has $500MM worth of assets. “Bank” extends E&P Co. a $100MM “Reserved Based Loan,” or “RBL,” secured by all of E&P Co.’s assets. E&P Co. also issued $200MM of unsecured notes (“Notes”).
A typical RBL has many covenants (i.e., requirements). One such covenant is that E&P will not draw from the revolver beyond the value of the “borrowing base” (the amount that may be drawn on the revolver). The borrowing base is based on the value of the reserves, and is usually designed to ensure that the value of reserves always exceeds the drawn amount of the loan by at least 1.5x. Another typical covenant is that E&P Co.’s EBITDA must cover the interest due on the RBL, usually somewhere between 1.3x – 3.0x (called an “interest coverage ratio”). Under a typical RBL, failure to deliver a clean “going concern opinion” (an auditor’s opinion that E&P Co. likely will survive another twelve months) is an event of default.
The Notes E&P Co. issued also have restrictive covenants, and a default under the RBL will constitute a default under the Notes.
The above-described capital structure is a very basic (but common) structure that can become much more complex. A more complex capital structure might include the use of different “tranches” of notes with staggered maturities, mezzanine debt, combinations of debt and equity, and ORRIs / NPIs (hopefully, owners of the ORRIs / NPIs have taken steps to protect themselves).
Oilfield Supply Co. (“OSC”)
Assume OSC is a service company that sells pipe, connectors, and other similar equipment, to exploration and production companies, including E&P Co. OSC must have inventory on hand to meet E&P Co.’s demands, as E&P Co. is drilling wells and performing other operations in the oil field. Thus, OSC has a yard full of pipe and a warehouse full of other oilfield supplies. To finance its acquisition of inventory, OSC borrowed from a traditional lender under an asset based loan (“ABL”) that is secured by all of OSC’s assets.
Energy Prices Start to Fall
When oil was selling for $100/barrel, E&P Co. was drilling numerous wells and ordering pipe from OSC on open invoices due 30 days after delivery. This arrangement was in place for quite some time and has worked well for the parties. However, over the course of six months, the price of oil dropped to around $50/barrel and hovered in that range for a short period of time. No one is quite sure what prices will do in the near future.
OSC will see the first effects of the falling oil prices, and will provide the first opportunity for private equity to acquire distressed assets. The opportunity may be to acquire some or all of OSC’s assets or, as discussed later, to potentially acquire OSC as a going concern.
E&P Co. believes prices will stay low until end of 2015. Fortunately, E&P Co. has plenty of cash on hand to fund its operations and has only drawn $25MM of the $100MM RBL, so it is not in any immediate danger. However, at ~$50/barrel, it does not make sense to drill new wells in the more expensive plays. E&P Co. may decide to drill new wells only to the extent necessary to hold acreage or, if it does drill more than the bare minimum, it may not be as aggressive (for example, E&P Co. may drill 2 wells instead of 5).
E&P Co.’s decision to scale back drilling has an immediate impact on OSC. OSC needs to sell its inventory to meet its debt obligations under the ABL. However, because E&P Co. has slowed its drilling program (and asked for price concessions on future business), OSC is not selling as much inventory and starts burning through its cash to survive. If the drilling slow-down continues for an extended period of time, OSC will be in real trouble. To stay afloat, OSC needs to renegotiate the terms of its ABL with the lender, sell a chunk of assets, find a new infusion of capital, or make some other arrangement. This scenario presents several different opportunities for a private equity investor to make a play at distressed prices while also providing needed liquidity to OSC.
Every six months, Bank (i) “re-determines” E&P Co.’s borrowing base to ensure sufficient collateral to cover its loan and (ii) makes sure E&P Co. is in compliance with other covenants (interest coverage ratio, etc.). E&P Co. previously had a reserve value of $500MM, but that was when oil was at $100/bbl. Now, with oil at $50/bbl, the value of E&P Co.’s reserves is approx. $250MM. The lower reserve value does not trigger a default under the RBL because the reserves are still worth more than 1.5x the $25MM that is drawn. Nevertheless, the lower oil price has put E&P Co.’s ability to meet the interest coverage ratio into jeopardy because it is selling the oil at $50/barrel, which may not produce enough revenue for EBITDA to exceed the interest due by 1.3x – 3.0x. If E&P Co. is not able to meet the interest coverage ratio, it will be in default under the RBL, Notes, or both (as mentioned above, many times, the RBL and Notes will “cross-default” such that a default under one triggers a default under the other). This has caused E&P Co.’s stock price to plummet (if publicly-traded) and the Notes to trade at less than par (face value).
In an effort to prevent a default under the RBL or Notes, E&P Co. needs an infusion of capital. This could come in the form of additional equity, a sale of assets (note, very often, the RBL and Notes contain restrictions on what assets can be sold and what can be done with the proceeds), or a refinance of the RBL or Notes, any one of which can be provided by a private equity player looking to place cash for a return. Obviously, the purchase of equity will be at a steep discount, the sale of assets will be at depressed prices, and a refinance of the RBL or Notes will be at a higher interest rate (plus fees), but can buy E&P Co. some time to survive until energy prices recover.