Tuesday, October 15, 2019

What happens to oil prices when producers have to be profitable?

Back in early 2015, I had an email conversation with the CEO of a small oil and gas company that had distressed debt. I asked him what his plans were for the company's capital allocation given the situation. His response:

Our guidance is $90-110MM of capex with $73-93MM allocated to the TMS. We have the flexibility of slowing down further if commodity prices stay low as we will be down to one rig on a well-by-well basis. Our well costs have continued to come down and our IRR in the TMS is now higher than the Eagle Ford which is why the allocation.
That was it. I responded by saying:
It's good to hear that the well cost is coming down, and I am glad you are maintaining flexibility.

I'm curious, do you think the IRR of the TMS wells you can drill this year, even with lower cost, is higher than the current yield to maturity of the company's debt? If not, then the strictly rational move would be to buy back the notes that are yielding 40%.

I realize that the rate of return of the TMS wells is unknowable because it depends on the future path of oil prices. But a guaranteed 40 percent return is tough, tough hurdle for any capital project to beat.

Here's a mental inversion technique that will help put it another way - let's say you were the CEO of a new oil company that was being founded on Monday. If you were offered the chance to borrow $100 million at 40% interest to drill TMS wells, would you?

As a distressed investor I see far too many managements go for broke rather than taking steps to save the company when storm clouds are gathering.

The company's stock has rallied back to beginning of January levels, but the bonds haven't. More ominously, the 2019 bond has a higher yield to maturity than the later maturing bonds. That's called an inverted yield curve. It means that the bond market is valuing your debt based on expected recovery value in a bankruptcy.
Never got any response. The company went bankrupt about a year later and the second lien creditors got 100% of the equity. Both the unsecured debt and the shareholders were wiped out. The second lien recovery was estimated in the plan to be 22 cents on the dollar. (I have not checked what the recovery actually ended up being given the current trading price.)

The CEO is still the CEO! The noteholders (big asset management firms) who lost so much money on the second lien notes kept him on and dealt him back in with stock. In 2017 his compensation was $3.7 million and in 2018 it was about $1 million. 

Public company managers have it unbelievably good. If they have a success, they take credit and a huge share of the reward. If they have a failure, they might be like this guy and considered blameless. It seems that even professional investors (providers of capital) view the job of the oil and gas company CEO as producing oil and gas rather than as growing their capital.

If that CEO had been a good steward of capital (mostly bondholders' capital at that point), he would have slashed capital expenditure to zero earlier. His capital allocation decisions made no sense given his capital structure and cost of capital.

Beyond a tale of principal-agent problem and mental inversion as a tool to have in the toolbox, these oil shale capital expenditure stories may say something about the future price of oil. Investors in shale E&P companies - not just buyers of shares but the lenders - have subsidized oil production over the past five years. (You can sort of see this in a chart of XOP or a natural resources mutual fund.)

In our recent Distressed Debt Watch (September 2019), we mentioned three oil producers: Approach Resources (AREX), Denbury Resources (DNR), and California Resources (CRC) that have bonds trading at distressed prices.

Approach Resources is the closest to filing for bankruptcy. The stock is down to 12 cents, they are in their seventh forbearance agreement with their lenders (which expires on October 15th, and the yield to maturity on their June 2021 note is over 90%.

Approach went public in 2007, raising $106 million. They did additional offerings of stock in 2010, 2012, and 2013. All together the balance sheet shows $744 million of paid-in equity capital. Their remaining capitalization currently consists of $321 million of senior debt and $85 million of the (distressed) notes.

This is an interesting test case of what happens to a high decline rate producer when it stop drilling wells - which Approach has, slashing capital expenditure to only $1.7 million in the first half of 2019. Total production of oil and gas (Mboe) was down 17% year over year for the most recent quarter - which was down 1.75% from the first quarter.

Their EBITDA + restructuring expense for the first six months of 2019 was $12 million. Meanwhile, the interest expense on their debt (which is about a 7% coupon) was $14.2 million the first half of the year. This makes it pretty obvious that the present value of their production is worth less than their debt.

So they have been drilling wells that are uneconomic (as we have seen with other companies like GMXR) and slowly building up an unpayable debt load.

Approach had been producing about a million barrels a year of oil - plus the equivalent, energetically, of another three million barrels of natural gas and natural gas liquids, which are far less valuable). Based on the most recent quarter's production, it will now be more like 800k barrels of oil and 2.7 million additional barrel equivalents.

They lost $17 million pre-tax in the most recent quarter, producing 199k barrels of oil. That's a loss of $85 per barrel, ignoring the other hydrocarbons produced. Wow! Even adding the 323k barrels of natural gas liquids (for which they received $12.50/bbl compared to $56.50/bbl for oil), they would need to earn an additional $53 per barrel equivalent to break even. If we add back their $7.4 million in interest expense but treat the NGL barrels as 1/4 as valuable as oil barrels, then they would need their realized price for crude oil to be $34 per barrel higher.

Those calculations are just to break even on operating expenses and depletion - they ignore the need to earn a return on the $1.98 billion of capital invested in their oil and gas properties (or the $1 billion of capital net of depreciation).

Something else this calculation tells you is that oil consumers have been subsidized by the equity and debt investors of Approach. Just like Uber riders and WeWork tenants were subsidized by their investors.


Anonymous said...

This was an excellent article and represents the main problem in this industry at this time with prices where they are, and have been for quite some time.

If you get a chance, analyze the debt/equity situation at OBE (Obsidian Energy). They have 120m capex with an equity of 70.... Let me know if you get a chance to peak at this one

CP said...

This process is intended to evaluate the Company's strategic options and alternatives to maximize shareholder value. Such strategic alternatives may include, but are not limited to, a corporate sale, merger or other business combination, a disposition of all or a portion of the Company's assets, a recapitalization, refinancing of its capital structure, or any combination of the foregoing.


Rachel Adams-Heard said...

Hi, I'd love to talk to the author of this post for a story I'm working on. My email is radamsheard@bloomberg.net.

Anonymous said...

Hey Rachel Adams-Heard, why don't you do your own work instead of stealing from others and passing off as your own.

This right here is why nobody likes of trusts any media, especially Bloomberg....