As we entered 2016, crude oil sat at $33 per barrel, down from more than $100 as recently as summer 2014. The naysayers in January, Goldman Sachs among them, predicted a plunge into the $20s, if not lower. Bearish sentiment crept beyond energy markets as the Dow sold off from nearly 17,500 at the start of 2016 to below 16,000 by February. This was it. The “barbarians were at the gate.” The leverage and exuberance were finally going to bring the system down. Or perhaps too many people went to see “The Big Short.” March rolled around. The Dow roared back above 17,500 in only four weeks. Oil flirted with $40.
So as we reflect back on Q1 2016, the question for energy markets is: where do we stand? Has oil bottomed and are we waiting on another 5-8 year cycle of sustained growth? Could prices go back down? Are prices in the $30 – $45 range here to stay? If so, how does the industry pivot to profitability with that price dynamic?
The answer: nobody knows for certain. There is a confluence of two events during our current 2Q 2016 that should caution the bulls and will provide substantial headwinds to optimistic management teams in Houston boardrooms and other oil cities:
- The pending bank re-determinations of revolving credit facilities
- The regulatory environment with governmental agencies cracking down on firms perceived to be in dire financial straits (or potentially on their way there following the item above)
In the half-decade boom between 2009 and 2014, the overwhelming majority of oil companies got drunk at the trough of cheap credit. Equity was cheap; debt was cheaper. Firms routinely out-spent cash flow, consistently re-investing profits back into more drilling which, in turn, enabled them to book more reserves on their balance sheets.
It is these reserves that are proving so problematic right now. The most common type of secured lending in the oil patch is the RBL or “reserve base lending;” a non-recourse loan with a value derived from the present value of future production. The current challenge is that loan is secured by the reserves themselves. When the oil company defaults, the issuer can seize the reserves.
Most Exploration & Production (E&P) companies have their facilities “re-determined” twice a year, once in the spring and then again in the fall. In 3Q and 4Q 2015, banks were reticent to reduce borrowing bases too much and foreclosing was virtually unheard of. Banks are now publicly confirming that regulators are refusing to let them “kick the can” on underperforming loans into this fall (foreclose or write down a bad loan and instead postponing those options for a later time). The regulators are demanding a realistic valuation of the RBLs.
Bear in mind, that many of the credit facilities were authorized when oil was $100/bbl and therefore far more generous. Marking them at the current strip price means scores of oil companies will see their credit facilities shrink drastically. Oftentimes these same oil companies will be over-drawn on the limit of the re-determined facility and typically without the cash to pay down the debt to regain compliance.
Therein lies the challenge. What do the banks do? Give a forbearance? Force the borrower to issue equity which is incredibly unappealing and potentially impossible with the current stock price? Or do the banks foreclose? The banks, regulators and oil companies all have a very difficult dance to do throughout the pending re-determination season. The wider market will be watching with interest as fortunes are lost, but opportunity presents itself.
This is the first post in a three-part series about the Energy market. Please view the next two posts in the series: