Given the collapse in prices and the carnage in stocks, a review of "the playbook" for distressed companies may be warranted for 2019.
Activities of companies with respect to property acquisitions and divestitures, corporate M&A, and debt and equity markets are summarized and reviewed.
Long time readers of my articles on the Bottom of the Barrel Club realize that I spent the first half of 2018 bemoaning the fact that every time the E&P sector started to show some life, it was knocked back down, a process I compared to "Whack-A-Mole." Well, in the second half of 2018, that process was more like a meeting with "Lucille." For those of you who may not be familiar with "The Walking Dead" TV series, Lucille is a barbed wire wrapped baseball bat wielded with savagery and much blood by the main villain in the show.
From June 29, which roughly coincided with the OPEC meeting that month, through Dec. 31, BOTB Club stocks crashed by (-55%) on average. Exactly ZERO stocks increased in price, and if I included two stocks that declared bankruptcy since July 1, the numbers would be even worse. Overall, my watchlist of 70 E&P stocks was down (-45%), so the damage was not much greater in the BOTB Club than it was elsewhere within the industry.
Given how much the markets have changed since 3Q results were reported in November, I have decided to use this article more to summarize actions of consequence to companies rather than specific results. Whatever guidance has been given even recently is at risk until revised guidance for 2019 capex, reserves, production and financial metrics gets disclosed beginning later in January.
One change for this article is to include all of the original BOTB Club members, including those who have been included in the X-11 Club grouping of companies who have declared bankruptcy since the start of the BOTB Club. This marks the 3rd anniversary of the formation of the Club, so showing performance for both groups and discussing items of interest seems the best route to take, this one time only. I will be paring back on the number of companies I actively write about and/or include going forward and will reconstitute the various groups in some fashion … and there will still be a BOTB Club since the designation if primarily a relative one (i.e., there is always a top, middle and bottom group the market "creates.")
Elements of a typical "playbook" restructuring scenario are set out below and are taken from a previous article of mine dated Dec. 2015. Unfortunately, even though companies may have undertaken some of these steps already, 2019 is shaping up as another year in which the playbook needs to be consulted. The items are presented somewhat in the order of desirability from the standpoint of any distressed company, and without intending for this list to be inclusive of all options:
The process above is iterative, and it also draws on the experience of other E&P companies' restructuring efforts. Once a particular strategy is defined that the market sees and likes from any company, other companies then mimic that strategy. So far, few distressed companies have achieved what could be considered a safe cushion or escape velocity with restructuring attempts; several have declared bankruptcy after being unable to reach agreement with creditors on the steps necessary to avoid a filing.
It really would be nice not to have to write about such things on a regular basis, but that is the environment that still exists for much of the E&P sector, particularly at levels less than a $50-60 range for oil for unleveraged companies and higher prices than that for leveraged ones. The fact that over $200 billion in E&P debt comes due by 2023 is an ongoing concern, although the progress or lack thereof will not be as sharply in focus at all times simply because the timing is more drawn out for non-bank debt than it is for bank debt. If nothing else, the Playbook helps when companies indicate they are "pursuing strategic options" or similar verbiage, because whatever they are considering probably appears somewhere on the list above.
It's another of my tributes to The Walking Dead to start an article with a nod to companies we have "lost" since my last article. For the 2H '18, that means saying 'goodbye' to Gastar and Petroquest.
Gastar's financial difficulties have been chronicled since Ares Capital Management took over Gastar's credit facilities back in 2017. Hoping to jumpstart Gastar's development program, Ares offered a bit more financial freedom to Gastar, but over time, Gastar's development program produced poor enough results that not even Ares' decision to PIK some of its debt created enough flexibility to continue, especially with underperformance of the drilling. Long story short, by July Ares was seeking to cause Gastar to offer the company for sale, and such an effort was completed in October with no successful bids resulting from that effort.
Gastar filed for bankruptcy on Oct. 31, 2018, after having $335 million in assets as of 3Q and $375 million in debt, all owed to Ares. Discretionary cash flow (cash flow from operations minus changes in balance sheet assets and liabilities) for the 9-month period was less than $20, clearly insufficient to service the debt without asset sales, at a minimum. The bankruptcy filing also gave rise to a substantial "Make-Whole Premium" that was allegedly owed to Ares for the default caused by the bankruptcy filing itself.
Despite testimony presented in a hearing before the bankruptcy judge, neither an equity nor a preferred equity committee was appointed, the judge feeling that the values involved clearly would not warrant a recovery by either group. Therefore, common shareholders were granted $150,000 and preferred shareholders another $150,000 (plus up to a combined $300,000 in reimbursements for attorneys' fees) as part of the plan settlement. Emergence from bankruptcy could occur any day, but since the company will be private and have only Ares as its sole shareholder, no public involvement is expected.
Few readers probably take the time to read through bankruptcy filings, but I always make it a point to at least review the liquidation analysis and the financial projections that are attached as exhibits to the Disclosure Statement, because they offer insight into how the bankruptcy process works and also may provide clues as to how a company may fare coming out of bankruptcy. The charts below show the data from Gastar's Disclosure Statement; the first 2 charts show how Gastar's financial advisors calculated the liquidation value of the company (which they estimated at roughly $300-375 million), and the remaining charts show financial statements on a go-forward, "ongoing concern" basis post-bankruptcy. In every bankruptcy, the debtor must be able to show that the estimated ongoing concern case value exceeds the estimated liquidation value, and in this case (as in the case of most others as well) the judge concluded that was the case. Of course, by having Ares convert its debt into equity, Gastar is expected to free up substantial development drilling dollars, funds it could not have obtained but for the bankruptcy filing. Cumulative capex over the 3-year period following emergence would total over $650 million, which of course was based on expectations at the time the schedules were prepared in December.
(Note: to view any of the charts in this article, click on them and open them in a new tab, then enlarge or reduce for best viewing.)
Turning to Petroquest Energy, the company filed for bankruptcy on Nov. 6 under a pre-packaged plan with its creditors. As of Sept. 30, Petroquest had assets of $130.4 million and debt of $334 million, resulting in shareholders' equity of negative (-$258.5) million, net of a preferred issue of $75 million. Operating cash flow for the 9-month period was less than $20 million.
Under its Plan, Petroquest 2L creditors will receive 100% of the equity in the reorganized company, as well as a pro rata share of $80 million in new 2L debt (the bank facility will remain unchanged at $50 million. Like Gastar, Petroquest will be a private company and is expected to have its Plan approved sometime in 1Q '19.
BOTB Club: Sanchez Energy (SN) received a continued listing notice from the NYSE on 12/21. They will have 6 months to get back into compliance.
X-11 Club: Jones Energy (OTC:JONE) had received a continued listing notice on May 28 and was removed from trading on the NYSE effective Dec. 13. Its equity market cap had fallen below the $15 million minimum, and a 1:20 reverse split failed to improve that.
The chart below shows the highest yielding bonds of each company in the BOTB Club. Obviously, and has long been chronicled in my previous articles (and referenced above), Sanchez and Jones are at the top, with "yields" approaching 100% (probably because they are not expected to pay future interest payments prior to restructuring). Legacy Reserves (LGCY), Ultra Petroleum (UPL) and EP Energy (EPE) are the next highest, with yields between 35-50%, also likely indicators of some sort of non-immediate restructuring looming. Other companies with yields greater than 10%, often denoted as the highest risk companies, include California Resources (CRC), Eclipse Resources (ECR-OLD), Comstock Resources (CRK), Halcon Resources (HK), Denbury Resources (DNR), Approach Resources (AREX), and Northern Oil & Gas (NOG).
Several of the above companies would not have appeared on the list, and the list would have been shorter, merely a few months ago. However, with the near-collapse of the E&P debt markets and wholesale liquidation of bonds and equity both, the list has grown. Although the inclusion of this chart is not a prediction, the methodology has proven to be pretty accurate in assessing the risk of restructuring, even back to 2016 when similar bonds traded at very low prices. Also, while many of those who purchased bonds back in Feb. 2016 or thereabouts made good trading profits, many more who purchased them to participate in restructuring have now given back any profits and, in some cases, have losses, due to the performance of the former bonds as new equity.
BOTB Club: Sanchez's borrowing base was cut from $380 to $315 million. MidCon Energy Partners' (MCEP) borrowing base was increased to $135 million.
X-11 Club: Chaparral Energy's (CHAP) borrowing base was increased from $265 to $335 million; a requirement of the deal is that Chaparral hedge 85% of its production for 24 months even though there is currently no bank debt outstanding (but see Debt below). Talos Energy's (TALO) borrowing base was increased from $600 to $850 million following its merger with Stone Energy. SilverBow Resources' (SBOW) borrowing base was increased from $330 to $410 million. Halcon Resources' (HK) borrowing base was increased from $200 to $275 million.
BOTB Club: Northern Oil & Gas issued $350 million in 8.5% senior secured 2L notes due 2023. Comstock Resources issued $850 million in 9.75% senior unsecured notes due 2026. Denbury Resources issued $450 million in 7.5% senior secured 2L notes due 2024. Legacy Reserves swapped a total of $130 million in senior notes due 2020/201 for $130 million in new 8% convertible senior notes (convertible at $6/share) plus 105,000 shares of stock valued at $525,000. In a second swap, Legacy exchanged $5.8 million in unsecured notes for 2 million shares valued at an average price of approximately $2.20/share.
X-11 Club: Ultra Petroleum (UPL) completed a debt swap of approximately $505 million aggregate principal amount, or 72.1 percent, of its 6.875% Senior Notes due 2022 (the "2022 Notes") and $275 million aggregate principal amount, or 55.0 percent, of its 7.125% Senior Notes due 2025 (the "2025 Notes"), for approximately $545 million of new 9.00% Cash/2.00% PIK Senior Secured Second Lien Notes due July 2024 (the "New Notes") and approximately 10.9 million new warrants entitling each holder thereof to purchase one common share of the company. While the company noted this exchange as eliminating $235 million in face amount of debt, the NPV of the transaction is a change of less than 50% of that (because the new notes bear interest at 11% all-in vs. 7% for the old notes). Chaparral issued $300 million in 8.75% senior unsecured notes due 2023.
BOTB Club: Comstock acquired 6,124 acres in the Haynesville Trend by agreeing to pay $20.5 million in future drilling costs attributable to the seller's interest in exchange for an 88% working interest (a 12% "carried interest").
X-11 Club: Berry Petroleum (BRY) sold East Texas properties for $6 million. Bonanza Creek (BCEI) sold certain Mid Con assets for $117 million, comprised of assets with 12 mmboe producing 3,000 boepd (55% oil). Halcon sold its water infrastructure business for $200 million in cash plus up to another $125 million in contingent payments based on achieving future growth targets. Legacy sold various assets for $22 million. Penn Virginia (PVAC) sold minor properties in Oklahoma for $6 million. Riviera Resources (OTCQX:RVRA) sold assets in the Arkoma Basin for $68 million, including 37,000 net acres with production of 24 mmcfpd and reserves of 111 bcfe and a proved PV10 value of $61 using $65/$2.65 pricing. Sandridge Energy (SD) sold assets in the Central Basin Platform of the Permian for $14.5 million. Ultra Petroleum sold Utah assets for $75 million. Vanguard Natural Resources (VNRR) sold assets in 4 separate transactions for a total of $31 million.
X-11 Club: Amplify Energy (AMPY) agreed to repurchase 2.9 shares at $12/share for a total of $35 million. Berry Petroleum authorized a $50 million share repurchase program. Midstates Petroleum (MPO) also authorized a $50 million share repurchase program. Riviera Resources repurchased via tender offer 6.1 million shares at $22/share for a total of $133 million.
BOTB Club: Contango Oil & Gas (MCF) issued 7.5 million shares at $4/share for gross proceeds of $30 million.
X-11 Club: Berry Petroleum conducted an IPO of 10.5 million shares at $14/share to raise $147 million, well beneath its original expectations.
BOTB Club: Chesapeake Energy (CHK) agreed to merge with WildHorse Resource Development (WRD) in a transaction originally valued at $3.98 billion. A combination offer of 5.336 CHK shares for each WRD share, plus $3/share in cash is the most likely outcome, at a value today of roughly $13.70/WRD share valued at $ $2.4 billion including debt assumption (WRD is trading at $14.11 today). WildHorse shareholders comprising a majority of the shares outstanding are already committed to vote in favor of the transaction, which will result in Chesapeake holders owning 55% of the combined company and WildHorse holders owning 45%. (See the Chesapeake/WildHorse Joint Proxy/Prospectus here and the Chesapeake presentation here.)
Comstock Resources completed a transaction whereby it merged with companies controlled by Dallas Cowboys' owner Jerry Jones in a transaction involving the issuance of 88.6 million Comstock shares valued at $620 million ($7/share). Jones now controls 84% of Comstock (see also Debt), and the transaction was treated as an acquisition by Jones of Comstock.
Denbury Resources agreed to acquire Penn Virginia in a transaction originally valued at $1.7 billion. In the transaction, Denbury will issue 12.4 shares and $25.86 in cash for each Penn Virginia share, which were trading at $79.60 on the date of the announcement. Based on today's prices, the consideration will be equivalent to $1.38 billion, or roughly $50.00/share after factoring assumed debt into the calculation. Penn Virginia shares closed today at $49.40. (See the Denbury/Penn Virginia Joint Proxy/Prospectus here and the Denbury presentation here.)
Eclipse Resources and Blue Ridge Mountain Resources (OTC:BRMR) are closing their previously announced merger on Jan. 3. Eclipse and Blue Ridge (formerly Magnum Hunter Resources) are merging in an all-stock transaction wherein Blue Ridge shareholders will receive 4.33 shares of Eclipse, originally valued at $7/share but now closer to $5/share. Blue Ridge shareholders will receive the equivalent of 219 million Eclipse shares, or roughly 14.6 million shares after the 1:15 reverse split that will take place prior to the closing. A majority of both companies' shareholders have already approved the transaction. (See the Eclipse/Blue Ridge Consent Solicitation here and the Eclipse presentation here.)
Legacy Reserves converted from an MLP to a corporation by issuing 27.3 million shares to former preferred holders, or roughly 26% of the 106 million shares outstanding, having a value at the time of $128 million (and $45 million at today's price). Also, Legacy subsequently issued 2 million shares and agreed to issue another 22 million shares upon conversion of its new convertible notes (see Debt above).
Resolute Energy agreed to merge with Cimarex (XEC) for stock (60%) and cash (40%) in a transaction originally valued at $35/share, or $1.6 billion including the assumption of $710 million in debt. Resolute shares currently trade at $29.53, and a 1Q '19 closing is expected. (See the Preliminary Cimarex/Resolute Joint Proxy/Prospectus here and the Cimarex presentation here.)
X-11 Club: Linn Energy agreed to merge its SCOOP/STACK assets with Citizen Energy to form Roan Resources (ROAN) after first spinning off its shares in Riviera Resources to shareholders. Former Linn shareholders will own 50% of ROAN (76.3 million shares), which closed at $19 post-split and now trades at $8.45 for its 152.5 million shares outstanding, or an equity market cap of roughly $1.3 billion.
Capex budgets: Capex budgets are usually released early in the year, although the late drop in oil and gas prices in 2018 might complicate matters for many companies. Estimates are that '19 capex budgets from independent E&P companies may be down 5-10% from '18.
SEC10 Reserves: Independent reserve estimates of volumes and SEC valuation are normally released in January. As a reminder, SEC guidelines mandate the use of prices for oil and gas that are the average 12-month trailing prices on the first day of each month. Because the last month in the year is December, December 1 prices will be in effect for all companies (as adjusted for location and other differentials). Prices for oil are already set at $65.66 and prices for natural gas at $3.05.
PV10: In this context, PV10 means the use of strip pricing to calculate reserve valuations. In recent years, when the PV10 was higher than the SEC10 valuation, companies have been quick to point out and reference the higher figures. This year that dynamic is reversed; strip pricing for oil for 48 months is $52.29 per barrel and natural gas is at $2.65 per mmbtu for the same period.
Guidance: Some companies have already issued 2019 guidance; most will have to do revisions at current prices. In addition to capex budgets, a primary focus for the investment community has been Free Cash Flow, or Operating Cash Flow less capex. Companies with negative FCF have been penalized severely, even when that result was an expected part of their strategy in the short term. Despite reduced capex, I expect production levels to increase on the order of 5-10% overall.
Hedges: I expect to see huge changes in the value of derivatives announced prior to formal earnings. Where companies may have had accumulated losses on their derivatives in 3Q '18 (and in many cases, large non-cash losses in their income statements), at year-end much of that will be reversed … and then some. In a few short months, investors have gone from criticizing management for having hedged at all, given the "inevitable" rise in prices about to come, to criticizing management for not having hedged at all, or not having hedged at the top. Ah, the benefit of 20/20 hindsight. As a matter of standard operating procedure, most companies will hedge the next 2 years' prices on a rolling basis and for declining production amounts. The industry is too cyclical and shale production too important during that period for companies to go unhedged, at least in the minds of management (and their creditors).
Differentials: The situation in the Permian Basin with respect to transportation bottlenecks has not improved much. Limitations on what can be transported have caused Midland to Cushing (NYMEX) WTI differentials to expand to double digits during parts of the 4Q, and quotes are currently (-$6.00) or so, declining back to near parity by the end of 2019. Natural gas prices, which reached as low as $0 in certain spot sale areas, are quoted at (-$1.60) through June, declining to -$0.70-$0.80 thereafter. With Henry Hub (NYMEX) prices of $2.90 for June and $3.00 at year-end 2019, that means that Permian natural gas prices may be in the range of $1.30 into June and slightly over $2 into year-end, at which time additional pipelines will be operational. In the 4Q '18 differentials in the Bakken Trend "blew out" to as much as $20 due to similar transportation constraints, so management discussion is important there as well.
Debt/Covenants: Needless to say, anything that companies disclose concerning their debt situation will be important to note, particularly if prices remain low. The OCC does not give banks or non-bank leveraged loan providers as much leeway as most equity investors want (which would be unlimited). As I have mentioned previously, despite all the talk about financial covenants like debt/EBITDA, etc., the most important factor and control the banks have is in setting the discretionary borrowing base. Companies that relied heavily on bank debt because interest costs were cheaper than non-bank debt have been paying for that decision when borrowing bases are re-evaluated, with the next redetermination scheduled for April. Also, the creeping maturities of long-term debt issues to within the period of the bank facility requires some evaluation by banks of the security of their own position.
Locations: Operationally, companies will routinely disclose rig counts and completion data; in most cases, the data disclosed is not particularly informative to retail investors. What is also important, though, is any discussion about spacing of locations, density, etc.; when terms like "interference" or "parent-child reductions" are discussed, these can be critical to assessing the number of "real" locations, rather than the theoretical maximum number that is often thrown out. Still, rumors of shale's demise are vastly overstated, in my opinion.
Accounting: I mention accounting treatment as often as I can, and frequently get questions about whether it is important to investors. Even though financial statements are not intended to be used for valuation purposes, I see daily reports that attempt to compare results from one company to another or across a sector without taking into account differences in accounting treatment. For example, terms like "book value," "P/E" ratio," "net income", "profitability," etc. all vary depending on what method of accounting is used, and computers cannot easily distinguish between methods when compiling data for research.
M&A outlook: One thing that I was reminded of as I compiled my notes for this article is how active the market for M&A has (finally) been for BOTB Club members. High-profile deals caught most of the media attention, but the space was very active (see #15 in the Playbook). In addition to those deals mentioned here, earlier deals like the Bill Barrett/Fifth Energy merger to create HighPoint Resources were notable. If prices had not crashed recently, I would have expected that trend to continue into 2019, but now, I am not so sure; to get companies to agree on pricing for deals often requires 6-12 months of stable prices, which is not the case currently.
Machines and Algorithms: I read a lot of comments bemoaning selling pressure when stocks are declining, but far less concern about purchasing pressure (imagine that!). With automated trading and sophisticated algorithms in place for 70-80% of all trades, by some estimates, my advice to investors is to accept that this is the case (and that "shorts" are no more likely to move pricing on the downside than "pumpers" are to move to the upside). I fall back on my own trading/investing strategy to minimize disruption, including treating preservation of capital as my #1 objective. If a stock moves against me beyond a pre-determined % or $ amount, I do not hesitate to sell even stocks I like, because it means that my entry point was not optimal (I am also not afraid to re-enter stocks I have sold). Based on learning valuable lessons from past market downdrafts, I keep losses to a minimum (usually) and let winners run, always with stops that will not let me or the market turn a good trade into a bad investment. FOMO often reigns in investors' minds, but E&P stocks are very volatile, so "missing out" is sometimes a good thing. Of course, everyone has their own philosophy; that is mine (and there is nothing at all wrong with using ETFs like XOP instead of individual stocks if that suits your style better).
Terminology: This is one to be a bit cautious about. The E&P industry loves acronyms, and it also loves fancy names that may refer to basic processes that are common across the industry but "captured" by company management and spun to give a high-sounding twist they hope will evoke "uniqueness." For example, Gen. 1.0, Gen 2.0, Gen. 3.0 have no common definition in the industry and refer only to a revised completion scheme (frankly, I'm waiting until someone tries Gen. 3.14159 … just so I can refer to a well as a "pi-hole."). Likewise, pad drilling, cube drilling, corridors, the "factory" model, etc. all sound like high tech D&C processes, which they certainly are, but the real focus should be on profitability and low costs, because that is how a competitive advantage is developed in an industry with few real barriers to entry.
The Majors: If you are planning to invest in an independent E&P company, why watch what the majors are doing? In short, because they're baaaack! Actually, they never really left, but the impact of their recent moves and what it means for the industry over the next several years or decades may be profound, especially in the Permian Basin. You see, back in the 1980s and 1990s, many of the majors decided to de-emphasize the U.S. due to their perception that international exploration presented them with the best opportunity to achieve the scale needed for them to grow. While they kept their Permian acreage, where they are the largest acreage owners by far, they reduced their activity level to harvest cash flow to redeploy elsewhere. However, in recent years, they have decided that shale plays are indeed worthy of their efforts, and they have spent large amounts of money on acquisitions to feed their growth plans until international exploration can gear up again. They need to invest huge sums on development drilling both to justify their deals and to grow production, and their projects are less dependent on what the price of oil is on any given day. Besides, they often own refineries, pipeline systems and chemical operations where they may make money even when oil prices are low. Their capex plans may well dwarf those of the independents ... combined, and their presence is one reason why oil production may grow faster than many expect going forward ... or not.
The chart below shows returns for the 2H and full year 2018, as well as other dates going back to July 1, 2014, which was the cycle high for the sector. You will note there is more red here than in a 'The Walking Dead' episode featuring Lucille, but there is not much sense in dwelling on the results. "Lower for longer" is still intact, going on 10+ years actually for both oil and natural gas prices, and that is a large part of what you see in the chart.
While much of this article may not read as positive, I think it is important each year to assess the actual state of the market at any given time, and also to keep track of positive events that could translate from one company's situation to another. As in the TWD, it is important to avoid the zombies, not be drawn to them … and to beware of villains wielding baseball bats.
Good luck to all in 2019, and here's to hoping for a better environment for E&P going forward … but being prepared with a sound investment/trading strategy to navigate through any pitfalls no matter what comes our way.
Disclaimer: Readers are cautioned to conduct their own research and analysis before investing in any securities described in this article. No specific recommendations are presented herein. All data has been obtained from public sources and has been checked for accuracy, but errors may still be present.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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