Despite today's strong oil and natural gas prices, many US independent oil and gas companies still are having trouble raising equity and are being forced to borrow money to finance exploration projects and property acquisitions.
"It reminds me of 1973-74. That's the last time I remember when the economics were as good as they are, and the (equity) markets were as bad as they are," said Bruce Lazier, principal and petroleum investment analyst of Ispyoil LLC in Dallas. "The small equity market is cursed."
John Herrlin, analyst with Merrill Lynch, said most exploration and production company stocks are near or above the stock price lows registered last year following the Sept. 11, 2001, terrorist attacks on New York and Washington, DC.
"That's absolute and not relative performance. Certainly, oil and natural gas prices are higher, but E&P stock valuation multiples are not meaningfully higher vs. this time last year. So stronger hydrocarbon prices haven't fully translated to the stocks since the market is questioning the sustainability of higher prices and visibility. These issues aren't new, especially in a bear market," Herrlin said.
Meanwhile, interest rates have declined over the last 10 years, he noted. "Unit interest expenses may have been one of the only unit costs to have declined meaningfully during this period."
Analyst Les Childress of the Seattle office of J.M. Dutton & Associates LLC said he has been concerned about overall E&P debt levels since the fourth quarter of 2001.
Companies trying to raise equity "have to have a really good story to get on anybody's radar screen…it has to be something special besides just drilling," he said. For example, companies holding significant mineral interests or having expertise in reworking older wells are more attractive to investors and can survive higher debt levels than can a pure exploration company.
Appropriate debt level
Too much debt relative to cash flow is considered a red flag to potential investors who are watching for financial capability.
"Investors should stay clear of highly leveraged companies," Childress said. Although he noted that each company must be judged on its own merits, Childress considers highly leveraged companies to be ones whose debt to total capital is 40% or greater.
"I'm adverse to debt, particularly for smaller companies, because they just have less room for error," he said. "Small companies' share price movements are heavily influenced by minor events or minor financial results. Small companies usually have thinner floats than large companies, so events can be magnifiedU(Individual) well news can move share prices."
Lazier believes debt to total capital generally should be no more than 33% and preferably close to zero for a small exploration company while an acquisition-exploitation company can run up to 50% because exploration risk is far greater than exploitation risk.
"The rule is: Use equity only for exploration and debt for drilling proven undeveloped reserves," Lazier said.
Herrlin sees most independents staying within normal debt ranges, although he noted that small and medium-sized companies might not be diversified in their assets, which makes them vulnerable to being "strategically or operationally challenged if they incur too much debt."
Survival study
On Jan. 31, consultant John S. Herold Inc. of Norwalk, Conn., issued the results of an oil company survival study. At the time, oil prices were averaging $20/bbl for West Texas Intermediate. The study examined which companies would suffer and which probably would survive if oil were to drop to $15/bbl.
After calculating the net debt to cash flow ratios and costs per barrel for 77 North American E&P companies, Herold found that nearly two thirds of US E&P companies would lose money if oil dipped below $15/bbl and natural gas fell below $2/Mcf for an extended period.
The study also evaluated the results for individual companies and determined "an apparent linkage between costs and debt" with low-cost companies also being low-debt companies. The Herold analysts said, "A significant number of the smaller US E&Ps are both high-cost and high-debt companies."
The study said, "Net debt-to-annualized cash flow ratios show a wide range of indebtedness, from the conservatively financed Canadian E&Ps (1.4 times) to the overleveraged small (US) E&Ps (2.7 times). The obvious conclusion would be that the more conservative Canadian E&Ps would be in the strongest position to take advantage of an industry pullback, while the small US E&Ps would be the group that experiences the most tumult. The large US E&Ps and midsize US E&Ps would probably muddle along, with the weaker players seeking merger partners for salvation."
Producers' comments
Oil and gas companies must compete with other industries for investors' dollars, said Thomas R. Kaetzer, president and CEO of GulfWest Energy Inc., Houston. He and other executives of the top 10 fastest-growing US independents—in terms of stockholders' equity growth—recently listed debt levels as a concern (OGJ, Oct. 21, 2002, p. 18).
"The last few years it has been difficult to raise equity, and if you can't raise equity, you've got to go borrow it. That's what we've done," Kaetzer said.
The equity market for the last 3 years has been drawn primarily toward technology and telecommunications companies, he said. "Who wanted to put equity into an oil and gas company? So now that capital is looking for a place to go, and I think that's why we're chasing the equity right now."
GulfWest currently has 60% debt over total debt equity, which Kaetzer called "much too high. We've grown from $8 million of total assets to about $55 million, and our debt equity stayed the sameU. Our interest payments per barrel are too high."
GulfWest is working to reduce its debt, as is Mexco Energy Corp., Midland, Tex., which had a debt-to-equity ratio of 40% as of Mar. 31 compared with 15% for its previous fiscal year.
Mexco spent $2.4 million last year on exploration, development, and acquisition costs vs. $950,000 the previous year, said Tamala L. McComic, treasurer.
"As we develop these properties and recognize income on them, we plan to pay the debt down to lower the ratio back down to where it needs to be," she said.
Nicholas C. Taylor, Mexco Energy president and CEO, said he likes for the company to have a debt level that can be repaid within 1 year from its cash flow.
"We have pressed beyond that point, and we will do it occasionally and temporarily," he said. "Our (future) production will be up, and we will pay our debt down."
Mexco focuses on working older properties with existing wells.
It also has relied on royalty income and mineral interests for 15-20% of its net income for the last 3 years.
