Last quarter my article in The Producer focused on Cost of Capital. This quarter I will address the impact of Capital Rationing on the market for direct oil and gas investments. Capital Rationing is a reflection of limited capital in an industry segment. Following the collapse in crude oil prices, capital in the oil and gas sector is now more disciplined, providing a greatly improved investment environment for Five States.
Cost of Capital is the price, expressed as a percentage that a company must pay for capital. Think of it as a weighted-average of the cost of debt and equity. For example, if debt costs 4% and equity 10%, and the optimal mix was 60% debt and 40% equity, then the Cost of Capital would be 6.4% (i.e., 4% * 60% + 10% * 40% = 6.4%).
This percentage is then used to value new investments. Financial theory assumes that a company will undertake any investment that will generate a risk-adjusted return greater than its Cost of Capital. Capital Market Theory assumes that companies that follow this discipline can raise unlimited capital (one of several unrealistic assumptions).
Most of the time though, there are limits on the capital available to a company. Capital Rationing is a term used to describe when companies are subject to this limiting factor. Capital Rationing is defined as “the act of placing restrictions on the amount of new investments or projects undertaken by a company . . . by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget.”1
Capital Rationing in the Oil and Gas Industry
Oil and gas companies have historically been subject to Capital Rationing. The oil and gas industry is extremely capital intensive. Most companies invest more capital on an ongoing basis than they generate from operations. This also applies to the industry as a whole. Most years the industry consumes more capital for new development than it generates in oil and gas income.
The additional funding is made up by the capital markets through bank loans, bond sales, stock sales or by direct investments in individual projects. Rarely does the industry have access to enough capital to fund all of the possible exploration and development projects. Companies have to prioritize, resulting in the less attractive projects not getting done.
Since the “Great Recession,” Capital Rationing has not been the norm for the oil and gas industry. The lust for income-producing assets, combined with the notion that the oil and gas business was no longer risky due to the statistical certainty of success in most shale plays, led to a huge increase in capital available to the industry.
Over the last eight years, total debt in the oil and gas sector has increased materially. Since 2002, total corporate bonds outstanding has increased over fourfold.
Debt and Leverage Increase in Energy Sector
There has also been significant growth in bank loans to oil companies with $1.6 trillion in syndicated loans as of 2014, up from $600 billion in 2006. (BIS Quarterly Review, March 2015). Total capital raised by the major oil and gas private equity funds has increased over tenfold, from $3 billion in 2001 to over $30 billion in 2014.
Energy Private Equity Fund Growth: 2001-2004
Source: Sage Road Capital presentation to IPAA Private Capital Conference, January 2015
In addition to the growth in debt outstanding and private equity capital growth is record stock issuance by upstream producers in Q1 2015 amounting to $10.8 billion.
Upstream Equity Issuances by Quarter
($ in billions)
Source: Tudor Pickering Holt & Co. presentation at DUG Bakken/Niobrara, April 2015
The confidence during the recent investment frenzy was fueled by the belief by many that oil prices could not fall below a certain level. The rationale of some was that the Middle Eastern sheiks needed a certain wellhead price to support their populace. Others reasoned that since the new North American oil plays were so expensive, prices had to stay at a level that made those projects profitable. But none of this has proven correct. Only two factors determine the daily wellhead price of oil: supply and demand. The oil supply increased and oil demand growth slowed.
Higher prices over the last decade stimulated the development of new oil supply. During this same period, worldwide economic expansion slowed. The difference between a tight oil supply, which results in high prices, and a surplus, which causes prices to tumble, is only a few percentage points.
Many companies are now in a debt or liquidity squeeze. Debt levels that just a year ago looked conservative are now proving to be too much. The following is an example of the “meltdown” of the financial condition of a hypothetical oil company.
Prior to the decline in oil prices, the hypothetical company on the following page looked healthy:
|Revenue (net of differentials & Severance Taxes)||$85||100%|
|Lease Operating Expenses & Overhead||29||34%|
|Interest Expense assuming line fully drawn||4%||7||9%|
|Cash Flow from Operations minus Interest Expense||$49||57%|
|Operating Profit Margin (Operating Profit/Revenue)||66%|
|Interest Coverage||7.6 x|
|Value as multiple of Operating Profit||5.5||x||$308|
|Senior Borrowing Base|
|Max Loan Amount based on an Advance Rate of||60%||$185|
Operating profit was 66% of revenue and debt was 60% of Total Asset Value. This resulted in strong coverage ratios. But over the last year, the decline in oil prices resulted in the following changes:
- Oil Price declined from $85 to $55, a decline of 35%. So Revenue declined 35%.
- Lease Operating Expenses and Overhead remained constant at $29.
- Therefore, Operating Profit declined 54%. The decline in Operating Profit is 50% greater than the decline in oil prices and revenue.
- Asset Value is estimated at 5.5 times Operating Profit. Asset Value decreased by 54%, the same as the decline in Operating Profit.
- Borrowing Base remains 60% of Asset Value. But since Operating Profit and Asset Value decreased by 54%, the Borrowing Base will decline by 54%.
When expressed in dollars rather than percentages, the negative impact of the financial leverage is devastating. (See table below). The Borrowing Base has declined from $185 to $86, a decrease of $99. The value of Total Assets has declined from $308 to $143, a decrease of $165. The outstanding debt of $185 is now greater than the revised Value of $143. This hypothetical company is now bankrupt.
|Before the decline in Oil Prices||Redetermination after the decline in Oil Prices||% Change|
|Revenue (net of differentials & Severance Taxes)||$85||$55||($30)||-35%|
|Lease Operating Expenses & Overhead||29||29|
|Interest Expense assuming line fully drawn||4%||7||7|
|Cash Flow from Operations minus Interest Expense||$49||$19||($30)||-62%|
|Operating Profit Margin (Operating Profit/Revenue)||66%||47%||-28%|
|Interest Coverage||7.6 x||3.5 x||-54%|
|Value as multiple of Operating Profit||5.5||x||$308||$143||($165)||-54%|
|Senior Borrowing Base|
|Max Loan Amount based on an Advance Rate of||60%||$185||$86||($99)||-54%|
If the company has hedges, the hedges might keep the company afloat for a year or two. But the impact is clear. If prices remain at this level, companies that had debt levels considered normal a year ago will have problems. Those that are not bankrupt become non-conforming or non-complying with their loan covenants, resulting in a primary source of their funding “drying up”.
Most independents had sold their production forward (hedged), locking in higher prices. But, most only sold forward for a year or so. Without a major correction in oil prices, a growing group of companies that are out of compliance with their borrowing covenants will become insolvent. We have seen companies where hedges were 25% or more of the tangible net worth. As those hedges roll off and the profit is used, that translates to shrinking total assets.
Even some large public companies are being impacted. For example, this month we saw two packages of properties totaling $1 billion in value for sale by a public company that is financially solid. Clearly management is taking capital rationing seriously.
During the boom both public and private companies were keeping assets that they traditionally would have sold. Public companies were keeping non-core and non-operated properties. Many of these properties were “mature annuities” with little or no development prospect. Because their cost of capital was low, they could hold these assets to try and slow the rate of decline in their reported reserves (total “barrels in the ground”).
Compounding this move to divestiture, many companies are reducing staff, so they no longer have the resources to administer these assets. There will likely be a move to selling off midstream assets such as gathering systems (pipelines) and storage facilities to free up capital for their core investments.
During the boom the industry had access to what appeared to be “unlimited” cheap capital. Now capital is limited and more expensive. This creates improved opportunity for Five States. We like “boring, no-growth” annuities.
In addition to the increase in public offerings, our business development team is hearing a different story from commercial banks and private companies than they did this time last year. Borrowing bases are eroding, and banks are beginning to put pressure on borrowers to take the necessary steps to bring their loans back into compliance. Some lenders are looking for ways to “play kick the can” by softening covenants and inflating forecast price decks. But these “tricks” only delay the inevitable. Without a material increase in oil prices, a major restructuring of the oil and gas sector will be necessary. This is about as good as it gets for making new investments in oil and gas!
We have several transactions in the pipeline on which we expect to issue term sheets or commit to participation over the next few months. At this rate we anticipate fully committing Five States Energy Capital Fund 2 this year. We will provide more frequent updates over the next several months.