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.

WSJ: "How Zombie Companies Are Killing the Oil Rally"

WSJ article - coal and oil are maintaining production during and after restructurings. Goodrich and Arch Coal emerged from bankruptcy recently and are ready to compete.

Goodrich Petroleum Shares Cancelled

"On September 29, 2016, the United States Bankruptcy Court for the Southern District of Texas Houston Division confirmed the Debtors' First Amended Joint Plan of Reorganization (“Plan”) for Goodrich Petroleum Corporation (GDPMQ). The Plan became effective before the open on October 13, 2016, and GDPMQ shares were canceled. Effective October 13, 2016, existing GDPMQ options are adjusted to no longer call for the delivery of Goodrich Petroleum Corporation Shares upon exercise."

Goodrich Plan Effective Date

Latest 8-K filing:

On September 28, 2016, the Bankruptcy Court entered an order (the “Confirmation Order”) confirming the Plan as modified by the Confirmation Order.

The Debtors expect that the effective date of the Plan will occur as soon as all conditions precedent to the Plan have been satisfied (defined in the Plan as the “Effective Date”). Although the Debtors are targeting occurrence of the Effective Date within the next 15 days, the Debtors can make no assurances as to when, or ultimately if, the Plan will become effective.

Holders of Company preferred and common stock will receive no recovery on account of their equity interests.

Goodrich Petroleum Bankruptcy Progress

[T]he Debtors request that the Court approve the following schedule of proposed dates:

Voting Record Date August 16, 2016
Conditional Disclosure Statement Hearing August 18, 2016
Start of Solicitation & Notice Date August 23, 2016
Voting Deadline September 21, 2016
Objection Deadline September 21, 2016
Confirmation Hearing Date September 28, 2016

Dockets for Recent Bankruptcy Cases

• Energy XXI
• Arch Coal
• Peabody Energy
• Goodrich Petroleum
• Linn Energy

Goodrich Petroleum Files For Bankruptcy $GDP

HOUSTON, April 15, 2016 /PRNewswire/ -- Goodrich Petroleum Corporation (OTC Markets: GDPM) (the "Company") today announced that it and its subsidiary has filed for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Texas, Houston Division, in order to implement the terms of that certain Restructuring Support Agreement (the "RSA") previously announced. The RSA and the bankruptcy proceeding will allow for the restructuring of the Company's balance sheet, which will strengthen the Company's financial position by reducing long-term debt and enhancing financial flexibility.

"Goodrich Petroleum Announces Results To Date And Five-Day Extension Of Tender Offer Period" $GDPM

The Goodrich Petroleum exchange offer that I mentioned a month ago, and which is far too greedy, looks like it is going to fail.

Exchange offers are a great idea for insolvent companies, but the nuisance value of equity is about 5%. Goodrich tried to get far more than that. So they'll either up the offer or file for bankruptcy.

"Goodrich Petroleum Announces Unsecured Notes And Preferred Stock Exchange Offers" $GDP $GDPM

Goodrich Petroleum announced yesterday:

Goodrich Petroleum Corporation today announced that it has commenced offers to exchange newly issued shares of common stock, par value $0.20 per share, for any and all of its Existing Unsecured Notes and for any and all shares of its Existing Preferred Stock. The Company has also announced it intends to offer to exchange its Second Lien Notes into new second lien notes with materially identical terms except that interest thereon may be paid either (a) at the Company's option in cash or in-kind or (b) deferred until maturity. The Second Lien Notes Exchange Offers, together with the Unsecured Notes Exchange Offers and the Preferred Exchange Offers collectively referred to as the "Exchange Offers" and the "Recapitalization Plan". [...]

If successful with the above referenced Existing Unsecured Notes Exchange and Second Lien Notes Exchange, the Company would eliminate between $213 million and $224.2 million in unsecured senior indebtedness with respect to the exchange and cancellation of Existing Unsecured Notes in the Exchange Offers, and $29.8 million to $31.4 million in cash interest payment obligations per year, thereby preserving liquidity in the near term. [...]

The Company is conducting the Exchange Offers in response to the current low commodity price environment that has had a significant, adverse impact on the Company. While the Company is not currently in default under its existing debt instruments, its ability to make the March 2016 interest payments on its 8.00% Second Lien Senior Secured Notes due 2018 and 8.875% Senior Notes due 2019 and service its other debt and fund its operations is at significant risk as a result of the sustained continuation of the current commodity price environment. If the Company is unable to complete the Recapitalization Plan, including the Exchange Offers, and address its near-term liquidity needs, it may need to seek relief under the U.S. Bankruptcy Code. This relief may include: (i) seeking bankruptcy court approval for the sale or sales of some, most or substantially all of the Company's assets pursuant to section 363(b) of the U.S. Bankruptcy Code and a subsequent liquidation of the remaining assets in the bankruptcy case; (ii) pursuing a plan of reorganization (where votes for the plan may be solicited from certain classes of creditors prior to a bankruptcy filing) that the Company would seek to confirm (or "cram down") despite any classes of creditors who reject or are deemed to have rejected such plan; or (iii) seeking another form of bankruptcy relief, all of which involve uncertainties, potential delays and litigation risks.

It looks like this would give 184 million shares to unsecured noteholders. The company currently has 61 million shares outstanding.

2016 Begins with Ultra Distressed Energy Companies on the Brink

Judging by the bond prices, many of these are likely to file in 2016:

• ZINC, the July 2017 3.8% note trading at 20 cents; ytm 155%
• GDP, the 8.875% notes traded at 8; current yield >100%.
• EXXI, the 3% notes traded at 6; current yield 50% and ytm 145%
• TC, the 7.375% notes traded at ytm of 134%
• SD, the 8.75% notes traded at 12; ytm >100%
• PVA, the 7.25% notes traded at 13; ytm>100%
• BTU, the 6% notes traded at 18.2; ytm 88%
• CLF, the 5.95% notes traded at 28; ytm 88%
• LINE, the 8.625% notes traded at 16; ytm 78%
• XCO, the 7.5% notes traded at 27; ytm 72%
• SSE, the 6.5% notes traded at 16; ytm 54%

Energy and resources. These companies have a combined market cap of $1.67 billion. In all likelihood based on the bond prices, that is illusory. Maybe in 2016 lots of illusory wealth will be revealed as worthless.

What if FB ad revenue that is funded by VC equity contracts, and the multiple contracts, and much of that $300 billion market cap is revealed as illusory? What if the Amazon flywheel runs in the opposite direction (both AWS, as an expression of the VC bubble, and the traditional business, as an expression of consumer spending), and some of that $317 billion market cap is revealed as illusory?

What if the replacement cycle on Apple devices lengthens, or consumers get tired of paying 100% markups for memory, and some of that $587 billion market cap is revealed as illusory wealth?

Well, then, we'd have a bear market.

Distressed Debt Update

• Peabody 4.75s traded at 5.75, current yield of 83%.
• Energy XXI 3s traded at 12, ytm of 97%
• Goodrich Petroleum 8.875s traded at 17, ytm of 92%.
• Linn Energy 7.75s traded at 19.4, ytm of 58%.
• Arch Coal unsecured debt was "0.75, flat" bid today. That's with coupons due on 12/15.

The equity in all of these companies is most likely worthless. At Arch, Peabody, and Energy XXI, the (subordinated) unsecured debt could also be worthless.

Recent Distressed Bond Trades

Yesterday the EXXI holding company 3%s due 12/2018 traded at 9.5 to yield 105% to maturity (32% current yield). The 9.25% note due 12/2017 has traded in the low 20s to yield 100%+ to maturity (40% yield to maturity).

Peabody did a 1:15 reverse split this morning. The 4.75% sub note traded yesterday at 11.5 for a current yield of 41%. The 6% note due 11/2018 has traded in the high 20s to yield 60% to maturity.

Goodrich Petroleum 8.875% note due 3/2019 has traded around 17 to yield around 90% to maturity.

The Arch Coal unsecured notes are trading in the single digits with current yields higher than 100%!

Linn Energy has a 6.5% due 5/2019 that's trading today for around 27, yielding 54%. Had been single digit ytm% as recently as May 2015.

It is astonishing how many companies have unsecured debt that is worthless. This of course is a sign that lending had become very sloppy.

Low low distressed debt trades

• RadioShack bonds traded last week with a 5 handle.
• The Walter Energy 8.5s traded at 6.25; massive current yield!
• The EXXI 3s traded in the high 20s - low 40%s ytm.
• Molycorp secured debt moved down about 15 points into the high 40s - around 30% ytm. People had gotten way too optimistic before earnings.
• The Molycorp 6s unsecured and the 3.25s unsecured are both single digit now. The 3.25 ytm is over 400%!
• Goodrich bonds have come down into the mid 40s again. That's a ytm inthe mid 30%s.

More Goodrich Petroleum News

• Capital expenditures totaled $73.4 million in the quarter, of which $68.8 million was spent on drilling and completion costs, $0.8 million on leasehold acquisition and $3.8 million on facilities, capital workovers and other expenditures. For the year, capital expenditures totaled $332.9 million, of which $295.1 million was spent on drilling and completion costs, $23.2 million on leasehold and property acquisitions and $14.6 million on facilities, capital workovers and other expenditures.
• As previously announced, the Company revised its preliminary capital expenditure budget for 2015 to $90 – 110 million, comprised of $80 – 100 million of drilling and completion capital expenditures and approximately $10 million of leasehold and infrastructure expenditures. The Company will monitor capital expenditures on a quarterly basis and maintain flexibility to accelerate capital expenditures with improvement in oil prices and the monetization of certain assets. Oil-directed capital is estimated to be approximately 91 – 93% of the total drilling and completion budget, with the entire oil-directed allocation to the Tuscaloosa Marine Shale, where the Company is seeing significant reductions in well costs, as authority for expenditures ("AFEs" ) have decreased from approximately $13 million per well in 2014 for single well pads to approximately $10 million per well for single well pads and $9.4 million per well for two well pads. The reduction in well costs is being driven by a reduction in drilling days from approximately 40 days to an average of 26 days (21 – 29 days per well) over the last four wells, and approximately 15 – 20% reduction in service costs. More detail is given in the presentation for the earnings release.
• For 2015, the Company has a total of 3,500 Bbls/day swapped at an average LLS price of $96.11 per Bbl.
• Following the sale of the Company's East Texas assets on December 22, 2014, the borrowing base of the Company's first lien credit facility was reduced to $230 million. The Company had $121 million drawn on its first lien credit facility at the end of 2014 resulting in approximately $109 million of available liquidity as the Company entered 2015.
• The Company has entered into an amendment to its first lien credit facility which extends the term until February 2017, amends the debt to EBITDAX covenant to 2.5 times secured debt to EBITDAX and sets the borrowing base at $200 million, which reduces to $150 million upon closing of the notes offering. The Company expects to finance the remainder of its 2015 capital expenditure budget with cash flow from operations and available capacity on its first lien credit facility.
• In addition, the Company currently has seven TMS wells drilled and waiting on completion, with plans to begin completion operations on these wells beginning late 1Q'15 through early 2016, pending better market conditions. Since the end of the fourth quarter, the Company has released two rigs, with one active in the TMS.

Goodrich Petroleum Borrows More Money Secured, Issues Warrants

News:

"The Company has entered into a definitive purchase agreement for the issuance and sale of $100 million aggregate principal amount of 8% senior secured notes due 2018 (the 'Second Lien Notes'), together with warrants to purchase up to 4.88 million shares of the Company's common stock at an exercise price of $4.66 per share, a 10% premium to yesterday's closing stock price. The Company has increased its liquidity and has the ability to issue an additional $75 million aggregate principal amount of the Second Lien Notes in the future.

The Company's first lien credit facility maturity has been extended to February 2017, the covenants amended to provide additional flexibility and borrowing base redetermined to $200 million, reduced to $150 million upon closing of the sale of the Second Lien Notes."

A commenter points out,

"So net, net, they got $50MM of liquidity, gave a 2nd lien position and diluted themselves by 10%"

These are the wild, ridiculous capital markets that we live in now. The funny thing is that the unsecured notes seem to be up on the news, even though they just got primed.

Comment On E&Ps and Service Companies

A correspondent writes,

"This is from the Dead Companies Walking blog. I’m seeing evidence of this in the companies that I own puts in. The drillers and service cos have started to roll over again, both stocks and bonds for the most part, but the E&P names like EXXI and GDP are not. May also be starting to see some differentiation in the E&P names – weaker ones are starting to roll back over while some of the other near dead like SD are still gaining altitude. May be time to take another look at them and some of the other service companies that weren’t quite as distressed on the first pass through.

'Every executive we spoke with said the big loser in a long-term lower-price environment would be oil service companies, as E&P firms are already demanding, and getting, lower prices for drilling rigs, as well as 25 percent or greater price cuts for supplies like frac sand and drilling mud and services like downhole engineering work and pressure pumping.

So what does all this mean for investors? Even if the recent rally in prices holds, oil services companies—especially those with hefty debt loads—will probably continue to struggle. Prices for their services will remain depressed, and if their debt obligations are onerous, lower revenues and cash flows might crimp their ability to make interest and/or principal payments. That could easily lead to a rash of bankruptcies in the sector. Exploration and production companies, on the other hand, should come through the downturn in better shape and bounce back more rapidly.'"

I don't know any servicers where puts are cheap. I think the cheap bet is E&Ps that will go BK next year if they don't get the oil bounce that everyone is counting on.

Distressed Bond Trades

• MCP 3.25s 2016 traded ~17 for a ytm ~200%.
• MCP 10s (secured) traded today ~ 56 for a ytm of 25%.
• MCP market cap is still over $200 million!
• WLT 9.875s 2020 traded a million+ yesterday at 13.5, ytm of 82%!
• RSH unsecureds (defaulted) have been trading in the mid-teens
• GDP 2019 paper has rallied a few points, but still ytm 35%

Goodrich Petroleum President & COO Robert Turnham at EnerCom Oil & Gas Conference 2014

Distressed Company Watch

Molycorp

• Molycorp 3.25s 2016; million+ bonds traded at 15.5 yesterday; yield to maturity of over 200%!
• Molycorp 10% (secured); million traded at 56.5 today; ytm 25%
• Molycorp 6s 2017; fair amount traded today at ~15 cents; ytm over 100%

Interesting that the 3.25s and 6s trade at the same dollar price even though there's a difference in coupon. That implies people think that the company won't be paying unsecured coupons much longer. And note that the 6s are a current yield of 40%! Yet, the company has a $245 million market cap.

Walter Energy

• The 9.875s of 2020 traded over a million today at around 16 cents; ytm over 70%. Note that's a 62% current yield!
• The 8.5s of 2021 traded a million bonds a week ago for about 14 cents; ytm of 70%. Again, a 60% current yield.

Those current yields are gigantic! Walter market cap is down to $75 million.

Energy XXI Ltd.

•  The 3s of 2018 traded 500k today at 33.25; ytm of 37%.

The stock was up 10% today though and the market cap is $380 million. (Enterprise value is $4.26 billion.) Their slogan is "Acquire. Exploit. Deliver" and they are mostly offshore GOM.Their current investor presentation [pdf] is a lot better about their plans to get out of the low oil price jam than most companies': less capex and use cash flow to pay down debt; sell pipeline assets to pay down debt; sell non-core assets.

Goodrich Petroleum

• The 8.875s of 2019 traded a good amount today at around 41 cents; ytm of 38%. 

That particular Goodrich bond is ~$275 million outstanding. At the current price, the debt has a market value of $110 million, which is about what the company plans to spend on capex this year. I would be surprised if their rate of return on capex would beat buying back these bonds. The company still has a market cap of $159 million.

Alpha Natural Resources

•  The 6s of 2019 traded multiple million at around 29; ytm of 44%. 

Company has a $280 million market cap and $3 billion enterprise value.

"TMS Operators ‘Deep-Out-of-The-Money’ Call Options On Oil"

"Tuscaloosa Marine Shale (TMS) play will still require crude oil prices of >$75/bbl, Baird analyst Ethan Bellamy said in note.

Infrastructure plans at TMS likely to be placed on hold until activity, production levels can reach scale needed to bring increased midstream infrastructure spend to the region"

Except for Goodrich - they are not placing their drilling on hold!