Last week our Energy Restructuring Team attended the Energy CFO Roundtable in Houston that focused on “Restructuring in the Oil Patch”. Stephen Lerner, the chair of our Restructuring & Insolvency Practice Group, was one of the panelists. In this blog we summarize some of the important takeaways from the Roundtable, along with our current thoughts and insights on the current turmoil in this sector.
“This cycle is different from 1986.”
Comparing this market to the 1986 crisis, Roundtable participants concurred that this downturn is different. Timing is expedited. Oil and gas can be extracted more quickly and cheaply and investors expect returns on their investments sooner. Investors are looking for returns in 36 to 48 months or less compared to much longer periods in 1986. Back then, waiting 10 years or longer was not unusual.
As Stephen noted on the panel, everything moves faster now and that includes the restructuring and bankruptcy process. In response to rapidly dropping oil prices, many companies have been faced with a severe lack of liquidity as borrowing bases have shrunk, service companies have been squeezed both in price and volume and lenders have begun to exercise their rights. This lack of cash has led borrowers and their secured, and often under-secured, lenders to pre-negotiate bankruptcy plans in advance of the actual bankruptcy filing through a restructuring support agreement (RSA). An RSA typically lays out the terms on which secured lenders are willing to provide debtor-in-possession financing in exchange for the debtor’s commitment to specific deadlines for conducting a process to either sell assets or confirm a plan of reorganization acceptable to the lenders. RSAs usually require a debtor to assume the agreement when in bankruptcy and to file and obtain approval of the deadlines and other commitments it contains. This expedites the bankruptcy process and puts pressure on unsecured creditors, such as suppliers and service providers, and equity holders who were not included in the negotiation of the RSA.
In short, the restructuring process is moving faster in 2015 and 2016 for energy bankruptcies than in the past. This new normal is placing significant pressure on debtors, creditors and equity holders to move swiftly in response to the current distress.
“There is an excess of supply but demand is slowing down.”
In a confusing conundrum, while global demand for oil is decreasing, supply is nonetheless increasing. The reason for this is our worldwide economy. Oil forecasters have long relied on China’s dependence on fossil fuels and that reliance is now in serious question. China’s economy is weakening and along with it comes decreased consumption. Recently, Exxon cut its forecast for annual energy-demand growth in China by almost a 10th to 2.2% a year through 2025. This month, oil prices fell 7.4% after the Chinese released data showing that diesel fuel use fell in 2015 from a year earlier. ESAI Energy, a consulting firm, recently reported that China’s oil demand growth rate between now and 2030 would be less than half of the previous 15-year period and well below many companies’ projections. The question now becomes if not China, who will buy the excess supply. As China’s gross domestic product slows, the drop casts a dark shadow over the prospect of oil prices rallying any time soon.
There was more bad news in January as the Wall Street Journal reported that supply exceeds demand by as much as 1.5 million barrels a day. With Iran’s ability to sell more oil with sanctions relief, the supply likely will increase further. This places pressure on global overflow storage facilities, creating the risk of an even steeper price crash if storage facilities reach capacity. The Roundtable panel concluded that the significant oil glut has been spurred, in part, by technology breakthroughs that unlocked more fuel reserves from the ground (e.g., fracking), OPEC’s continued maintenance of its production level, and weaker than expected demand. It is worth noting that just this week OPEC appears to have opened the door to reducing supply but it is too early to tell. In short, this confluence of factors makes this down cycle markedly different from any other because of the international economic issues at play and uncertainty as to when and how the market might stabilize.
“Currently there is a big mismatch in assessed value between distressed sellers and value seeking buyers.”
A common theme for the Roundtable panelists was the current spread between buyers and sellers of distressed oil and gas loans and assets. Banks are not selling loan portfolios right now because of the significant spread between the bid/ask price. Distressed investors and buyers are hovering around companies and lenders waiting for the price spread to close. Many expect the pricing gap to close after the March/April borrowing base redeterminations of energy company loans.
The reason for the big spread in the bid/ask price is the question of valuation. When there is the risk of an ongoing excess in supply and concerns about storage capacity, valuations for production and supply companies are going to be much lower than owners, lenders and investors expect simply because of the unknown, namely how long it will take for the oil and gas market to return to anything that reflects normal pricing and how long until there is a return on investment. Lenders and companies, used to relying on book value, are now wrestling with the need to consider testing book value quarterly in response to market volatility.
A recent example is Quicksilver Resources. Quicksilver’s assets were sold to BlueStone Natural Resources II in a bankruptcy auction this week for $245 million. When Quicksilver filed for bankruptcy in March 2015, it stated that its assets in the United States (the assets that were sold) were valued at $1.21 billion. Volatility in the oil and gas market led to the $245 million auction price. The bankruptcy court approved the sale to BlueStone on January 27.
Market volatility brings with it opportunities for energy companies, lenders and investors. While many companies will likely be faced with difficult restructuring choices, value preservation is possible. Avoiding (or at least anticipating well in advance) a liquidity crisis is the first step. That means companies need to be realistic and focus on the length of their runway. How long, based on current cash flow projections (and with appropriate sensitivity to additional bad news), can the company operate? The longer the runway the greater the opportunity for an exit other than bankruptcy. If, however, a bankruptcy is inevitable, greater time provides the opportunity to take reasonable steps to maximize value and enhance recoveries for stakeholders.
Alternatives exist and can include out-of-court restructuring agreements with existing parties and possibly new lenders and investors who have the ability to invest or hold for longer periods. Traditional bank financing may need to be replaced with alternative sources that do not have the regulatory overlay. The M&A market for stressed and distressed oil and gas companies can be expected to more formally develop in the next few quarters. Being acquired may be a more forgiving option simply by providing a better return and avoiding the administrative costs of bankruptcy.
If a bankruptcy ultimately provides the best alternative, possibly because asset buyers want the protection of a bankruptcy court order to approve a sale or other transaction, prospective debtors can preserve value and improve recoveries by making every effort to hammer out the terms of debtor-in-possession financing and/or plan of reorganization terms with the necessary counterparties in advance of filing bankruptcy. This will reduce costs and expedite the restructuring process. RSAs can be an efficient part of this process.
Lastly — a plug for considering mediation. These cases are complex and often involve multiple debtors tied together with multi-tiered operating and management agreements. Despite the best planning, what happens in one case can impact another. First and second lien lenders often find themselves at odds, particularly when the first lien lenders assert the second lien lenders are under water and there is no valuation information being circulated. Unsecured creditors and subordinated bondholders are often left out of the pre-bankruptcy negotiation process creating serious risks of objection once a chapter 11 case is filed.
Adding a mediator to the mix, both before and after a bankruptcy filing, can offer a new perspective and provide a check and balance on the parties’ expectations. Another benefit is that mediation provides a safe place for contested valuation matters to be discussed confidentially and vetted by a neutral third party. One has to wonder when RSAs will provide for mediation, at least post-filing, so unsecured creditors and equity (when appropriate) can be introduced into an organized negotiation process. Mediation has the potential to bring creditors and equity up to speed quickly and allow for disclosure and vigorous negotiation with the hope that the structure will prevent a broken RSA that jeopardizes debtor-in-possession financing and impairs recoveries more than necessary and instead provide for a workable compromise. Having a mediator and informal discovery, particularly on valuation, could make the process more efficient and level the playing field for parties not included in the initial negotiation of the RSAs.