I attended Hart Energy’s Energy Capital Conference in Dallas, TX on March 2, 2020 and came away with optimism despite negative headwinds facing the oil and gas industry. The good news is that capital is still available to the upstream oil and gas industry, principally in the form of reserve-based lending (RBL), alternative junior capital (debt and equity) financing and private equity. The catch? The target that the industry needs to hit to tap into that capital has narrowed, in some ways materially with respect to management team history, basin, financial metrics and liquidity.

Free cash flow continues to be king, with the rest of the “royal court” consisting of viable distributions, flat (maintaining production) to very modest growth, balance sheet liquidity, efficiency in operations and office (G&A) and well-defined plans with predictable, repeatable results.

Below are my impressions and takeaways from presentations and interactions with fellow attendees.

1. Capital Discipline - When free cash flow yield and implied return to shareholders is over 10% on a sustained (repeatable) basis, the market will buy in. A low capex-high dividend strategy works to bolster stock prices in this environment, but this isn’t sustainable and thus will be a prevalent challenge, according to Paul Sankey, managing director, Mizuho Americas.
2. Debt Wall - Over 70% of E&P bonds maturing through 2023 are either “stressed” or “distressed”, said Ray Lemanski, managing director and group head of credit research at KeyBanc Capital Markets. E&P issuers who have bonds trading below an 8% YTW have the ability to access the market and term out upcoming maturities; in the event the market backdrop improves for E&P issuers and crude prices improve to the $60/bbl level, issuers with bonds yielding 8%-13% should be able to access the high-yield market.
3. High-Yield Market Recovery For The E&P Sector – Lemanski elaborated that history has taught us there are seven common themes the E&P high yield market has gone through when re-opening. First, bond prices bottom out. Second, investor sentiment discount evaporates. Third, realized losses become realized gains. Fourth, investors see relative value. Fifth, stronger, more liquid credits test the market. Sixth, other existing credits follow suit. Finally, first-time issuers attempt to access the market.
4. Capital Markets Scorecard (Public Equity & Debt Perspectives) - Investors are demanding sustainable free cash flow and modest growth while reducing leverage metrics. Leverage below 1.5x is now the target – the industry has a way to go to meet that parameter. Bank leverage covenants can drive tough asset development decisions to generate necessary cash flow levels. Small to mid-cap companies will particularly struggle to flip to the sustainable free cash flow model (inflection point between capital spend and cash flow generated from development). Energy now makes up 3.5% of S&P (lowest point ever) – sustained outperformance by the industry will reverse the trend. When determining how to increase shareholder returns, dividends are easier to value than stock buybacks.
5. RBL Metrics Re-Defined - Advance rate for E&P RBLs remains 60%-65% of risked PV value, but pressure is on banks to evaluate employing a discount PV rate closer to 15%-20% rather than the historic 9%, subject to other considerations. Participants on this commercial banking trend panel (as well as discussion with lenders attending the conference) indicate metrics for new transactions generally are leverage below 2.0x and liquidity of 15%-20% of the approved borrowing base. In the past, to get a deal done with the bank, a producer needed to “check” +/- 75% of the boxes; today, they need to hit 100%.
6. Private Capital is Available (But There’s A Catch) - The main drivers on the front-end are: the asset and the management team, in that order. That’s probably a historical flip from years ago in terms of priority. Additionally, it’s more critical now that the management team has done it before as a collective “team”; there is less capital funding for teams pulled out of other companies. Private equity funds remain interested in ensuring alignment with management teams. However, this doesn’t necessarily mean reworking existing waterfall arrangements given LP’s expectations for meeting certain minimum returns that haven’t materially changed.
7. ESG Standards & Reporting Metrics Remain Murky - If you’re determining a place to start, follow the generally established goals, guidelines and information releases of the large corporate public E&P companies. The standards are all over the board currently, but they’re best defined to date at that large corporate level. The market hasn’t yet set hard and fast rules related to Environmental, Social and Governance (ESG) (it’s coming), certainly not in the public and private mid-to-small cap E&P space. For large fundholders of public E&P paper, the gatekeeper for investments are the ESG managers. This group has to sign off before the portfolio managers are given clearance to buy. Since there are no clearly defined standards, each E&P company should make the determination of principles to follow and establish a path and defensible approach prior to tapping into the capital markets.