SAM XU, COHNREZNICK CAPITAL MARKETS SECURITIES, NEW YORK, NY
COMPANIES ARE BRACING themselves for the current redetermination period. As borrowing bases are being redetermined by lender following regulatory requirements, it is likely that many companies will see those borrowing bases and associated availability decrease significantly. While some companies will be able to sustain a borrowing base with no material change for the future, we expect that the extended low commodity price environment, along with several other factors, will lead to a decrease in borrowing ability for the vast majority.
Exploration and production in the oil and gas industry is extremely capital intensive. In an effort to preserve liquidity and maintain a healthy borrowing base, companies have reduced some of their largest capital expenditures. Many companies have postponed drilling activities on certain assets; cut lease operating expenses (LOE) used to maintain and operate the equipment on a producing lease; and reduced general and administrative (G&A) costs. Many cost-cutting measures have already been undertaken due to the oil price downturn, so there are few, if any, further measures to take ahead of the upcoming redetermination period.
SHOULD E&P COMPANIES DIVEST ASSETS?
Many factors go into a lender’s decision to adjust borrowing bases for E&P companies during redetermination periods. Companies using reserve based loans (RBLs) to fund their drilling activities are subject to revaluation and redetermination twice annually, in the spring and fall. Borrowing bases in the fall of 2015 were not reduced as much as many industry experts originally anticipated. Some companies, in fact, had their borrowing bases reaffirmed. A smaller number actually saw their RBL facilities increase.
Companies that were able to scoop up available assets lessened the impact of a low commodity price environment. These acquisitions affect a borrower’s liquidity in the immediate period following purchase. However, the financial impact of these acquired assets can be offset by the fact that the companies are purchasing additional reserves and expanding their asset portfolios. Additionally, reductions in a company’s credit line can be caused by more conservative price decks. This effect is likely to be the case for the current redetermination period when the lenders are expected to further lower their forward pricing curves used to determine the borrowing base.
Companies generally have focused resources on core assets, or their primary cash flow generators if they have a portfolio of assets, rather than focusing their efforts on all of them. Some of the more successful companies over the past 10 years have targeted unconventional resources. Many E&Ps have used hydraulic fracturing and proppants in their drilling process to achieve high initial production (IP) rates from individual wells.
These unconventional wells have a large production decline after the first 18 months of production. In some basins, 30% of the reserves are produced within the first 18 months. As the well produces, the Proved Developed Producing (PDP) value associated with the well drops significantly, regardless of the commodity price. Unconventional wells receive the benefits of production and reserve replacement with a continuous drilling program. But, overall, we anticipate reserve value will be lower than it was last year.
Successful hedging is vital to mitigating price volatility. Gas prices have been relatively stable, especially in comparison to the decline in oil prices that began in summer 2014. The average price of oil in 2014 was $93.26/bbl. The price dropped to $48.69/bbl in 2015 and has now dropped further, to $34.68/bbl, as of our most recent data pull.
Companies that protected themselves with hedging have fared better than those that did not. Yet, even for those who bought longer hedges, many of those favorable hedges are rolling off this year, contributing to conditions that will impact a lender’s redetermination.
According to IHS, US companies have roughly 15% of oil and 19% of natural gas production hedged in 2016. Those numbers will be further reduced to 2% and 7% in 2017, respectively.
THE LIQUIDITY ISSUE: BETWEEN A ROCK AND A HARD PLACE
Liquidity will be this year’s key word in the oil and gas sector. Companies that are over-leveraged are likely to find it difficult to divest their non-core assets and generate the revenue needed to decrease their debts. There is significant financial risk in divesting certain assets in this price environment. These assets have the potential to be less valuable than the actual loan value that banks currently grant to the companies. Regulatory pressures from federal regulatory agencies, including the Comptroller of the Currency (OCC) and Federal Deposited Insurance Corp. (FDIC) have been pressuring banks to limit and reduce their exposure to oil and gas operators by tightening certain financial covenants and taking a more conservative view on revaluations.
This redetermination period will be critical in defining the industry’s path forward. The downturn in this recent cycle is likely to extend through the end of 2016, or at minimum, through the next several months. During this period, we anticipate that many companies are going to continue to focus their capital investment on their core assets and will be forced to sell their non-core properties. In addition to liquidation events, we anticipate E&P bankruptcies will continue to occur unless markets improve.