As Murphy’s law states, “Anything that can go wrong will go wrong”. This age-old adage can be applied to what the U.S. oil and gas industry has experienced through most of 2020. The U.S. shale sector continues to reel from low oil prices triggered by the COVID-19 pandemic, which cratered crude oil and refined products demand and a Saudi-Russia price war in March that resulted in a significant increase in crude oil production and, consequently, supply. The confluence of these events led to a series of bankruptcies and restructurings under the weight of heavy debt loads while operating in one of the worst industry downturns in history.
Forty onshore oil and gas companies have filed for bankruptcy through September 30, according to law firm Haynes and Boone LLP, involving nearly $54 billion in debt. However, the number of companies filing bankruptcy in 2020 still lags 2016, when 70 companies filed for bankruptcy.
Operators in Texas, southern New Mexico, and North Louisiana are among those feeling the worst of the downturn and most say regional oil prices above $50/bbl will be needed to substantially increase drilling activity, according to a survey of upstream executives by the Federal Reserve Bank of Dallas.
In light of these recent events, Opportune Managing Director Gary Pittman offers his thoughts on what’s different with this year’s downturn compared to the 2014-2016 cycle and if these trends will continue in 2021 against the backdrop of what’s expected to be continued commodity price volatility and a global pandemic.
What trends/themes are you seeing with respect to oil and gas bankruptcies/restructurings in 2020 compared to what we saw in 2014-2016? Do you expect these trends to continue in 2021 and will we see a significant level of consolidation in the industry as result?
Pittman: While similar issues exist in commodity prices driving restructurings, the 2014-2016 period was attributed more to a market correction to address companies that started during the shale boom with a higher commodity price environment and they weren’t positioned to succeed at lower pricing. And I would say this was more of a supply-driven downturn, resulting from the success of the U.S. in finding supply in oil and gas, which brought prices down.
In 2020, it was a macro event that hit a much larger population of companies as this was attributed to demand-driven reductions and a shock to the system compared to the 2014-2016 period. The COVID-19 pandemic coupled with the Saudi-Russian oil price war were obviously catalysts that drove commodity price volatility and consumer demand destruction.
Unlike the 2014-2016 period, the market to sell assets was much weaker in 2020 and many lenders couldn’t exit their positions. In the 2014-2016 period, there were more avenues to sale. For example, lenders such as JP Morgan have decided to credit bid their positions in the current market environment.
Also, given lower valuations in 2020 with creditors being secured lenders, it appears to me that there are more considerations given to pre-packaged bankruptcies with shorter duration than in the previous cycle. Also, unlike the 2014-2016 period, companies in 2020 have been shutting in wells and taking more draconian steps and there’s a much greater focus on fixing operations by cutting G&A and capital expenditures drastically in the current downturn. In the 2014-2016 period, it was more a deleveraging exercise.
In addition, you’re seeing lower leverage levels in 2020 as less debt is remaining on companies’ balance sheets. Lenders are pushing for a higher ratio of EBITDA-to-debt, which is forcing second liens and secured creditors to convert all their debt to equity and, in some cases, wiping out all of the debt.
As we look forward to 2021, we would expect the trends to continue in the short-term, especially when the year-end borrowing base redeterminations occur. The year 2021 is expected to be better than 2020, so you would expect bankruptcy activity to return to historical levels and decrease from 2020 levels.
Impact on production cuts will start to be felt, which will have a positive impact on pricing. However, I don’t see banks and lenders changing their strategies for their restructuring in 2021 because they’ll want to maintain collateral for companies, maintain strong EBIDTA and, in some instances, the willingness to take equity will still be there in 2021 until there’s a fundamental change in the market and transaction activity improves.
Regarding consolidations, I think there’ll be more mergers in 2021. As many of the funds and banks have taken an equity position, they’ll try to either exit out, merge with similar assets, or cash out their positions, especially if we see an improvement in market conditions next year. In some areas, it’ll be necessary for survival to gain economies of scale to compete so there’ll be a reduction of operating costs and G&A with the consolidations.
How do you see COVID-19 affecting oil and gas bankruptcies and restructurings as we head into 2021?
Pittman: The main impact is on global demand, which is driving down prices. Additionally, it has put more strain on HS&E (Health Safety and Environment) within organizations to provide a safe working condition and address the inherent challenges with that. From an operational perspective, it doesn’t have much impact on field operations, but more on the corporate side as people need to work from home.
It has also created a difficult dynamic for advisors to debtors, as in most instances, they need to interact remotely with both team members and company personnel, which is a lot more challenging. However, through Zoom and other technology, advisors have been able to overcome these issues. When everything starts opening back up, we’ll see what the new normal working environment looks like in the restructuring space.
As we close out 2020 and head into 2021, what are some options and/or opportunities that financially distressed E&Ps can look to weather the storm?
Pittman: Heading into 2021, free cash flow, along with liquidity, will be the most important factors. Hedge positions at higher pricing will be heavily relied upon, either to stabilize cash flows or provide liquidity by monetization. I think there’ll be a more disciplined approach to operating cost and development expenditure plans to the extent that they don’t lose their best leases, as well as continued pressure on G&A reductions to reduce overhead. I think also the current environment will give companies an opportunity to renegotiate improvements in their midstream and other contracts that have renewals in 2021.
Given there’s optimism that 2021 will be a better market than 2020, I believe M&A may have more traction to sell underperforming assets. Additionally, given historically low global interest rates, there are still relatively low-cost financing opportunities.
In every cycle the E&P industry has gone through, they’ve always created opportunities and, given the challenges in 2020, the resiliency of the oil and gas sector for the most part will continue to weather the storm in 2021.