It has been 5 months now since the Brent Crude price first dropped below $90 per barrel in mid-October and about six weeks since that benchmark began to find support above $48 per barrel, even climbing above $62 per barrel in February. While that rebound technically means we are in a crude oil bull market, it hardly seems like good times for oil producers, who have been taking turns during this earnings season announcing just how badly their revenue and earnings have been impacted by lower oil prices1. The impact of lower oil prices on revenue was easy to predict; but it seems harder to anticipate exactly what the lower prices may mean for transactions in the oil and gas sector. What does seem clear to us, given that forward prices for crude oil show steadily higher prices, though, is that many oil and gas production companies will be working hard to find liquidity to maintain key operations to enable them to capitalize on higher prices if and when they do materialize. That will require executives vigorously to explore all of the various opportunities available to them, which is likely to spur increases in the number and diversity of transactions executed by production companies.
Traditional Liquidity Sources are Limited
Independent producers whose revenues have been impacted by lower commodity prices may find themselves in dire need of quick infusions of cash and fewer opportunities for raising that liquidity than were just recently available. The first step we have seen virtually all production companies take is to slash drilling programs, which has reduced rig counts and negatively impacted oil field services companies. But these steps are unlikely to suffice for many companies whose financial covenants in loan facilities and public notes are being tested. For companies in that situation, additional debt may not be available at all or available at acceptable cost. Indeed, many companies will be focused on restructuring existing public and private debt that is too restrictive for the current environment. Depressed stock prices make equity offerings a poor choice as well, at least in equity offerings to investors with anything less than very long-term investment horizons.
Other Sources of Liquidity Must be Pursued
Instead of seeking out the traditional sources of liquidity, we anticipate that producers will pursue more creative methods of raising cash. One prime method is likely to be monetizing upstream assets. The most straightforward method for monetizing those assets will be outright sales to financial or strategic buyers and we expect the pace of those sales, which has been strong in recent years, to continue, if not intensify, in the coming year. In fact, some experts believe that current oil prices will stimulate aggressive portfolio restructuring and “a virtual gold rush of mergers and acquisitions.”2 Whilst lower commodity prices make it a poor time to use the sale of mineral assets, particularly non-producing assets, as a means of raising money, we do expect to see some transactions in which buyers have the ability to pay acceptable prices to sellers because they have access to less expensive capital, can take a long-term investment view, have a strategic view of an acquisition for portfolio management purposes or to acquire new technologies. There may also be situations of distressed sales by producing companies that run out of liquidity.
Equally, instead of outright sales at depressed asset values, we expect that sellers will look at other structures in monetizing assets. Joint ventures may provide an opportunity for sellers to realize immediate value for assets and maintain an economic interest in those assets until a future time when those assets might receive a higher valuation. We have also seen that joint ventures, when structured appropriately, are more likely to entice non-strategic buyers with alternative pools of capital and limited appetite for involvement in operations, such as private equity funds. However a sale of assets is structured, many sellers may wish to negotiate commercial agreements that provide them with continued operation of, or economic interests in, assets.
Issuances of equity and debt, and likely debt with equity conversion features, may also be potential sources of liquidity. Given the depressed valuations for publicly traded equity and debt for companies in the sector, as mentioned above, it is likely that alternative asset managers, who see a long term arbitrage opportunity, are likely investors for such instruments.3
No matter how hard some companies work or how creative they may be prepared to get, some companies simply will not be able to find adequate sources of additional liquidity that will allow them to continue to operate their businesses. Historically, the M&A market during a commodity downturn is active. For public companies that pursue the path of putting themselves up for sale the challenge will, of course, be realizing appropriate value for their shareholders. For other public companies, depressed equity values and activist investors raise the prospect of takeover activity or bids for management change. In that regard, management at companies who believe that a takeover or shareholder action is a risk during this commodity environment should re-assess, with assistance from their legal advisors, their takeover and activist shareholder procedures.