Beyond the capital drought: challenges and opportunities

President Obama’s inauguration advice to the country would seem to apply particularly to oil and gas companies: it’s time to “pick ourselves up and dust ourselves off” and, as this article addresses, apply ourselves to the current capital crisis with honesty, creativity and, dare we say, a little bit of hope. Above all, we should not let current challenges blind us to longer term strategic opportunities they may present.

First, let’s take a clear—eyed look at the battered financial landscape for oil and gas companies. As we write in mid— February, it is hard to remember a more volatile and challenging environment for the industry.

Due to the current financial crisis and the dramatic slowdown of economic growth throughout the world, the oil and gas industry faces a severe reduction in demand. This comes at a time when huge projects, built or planned when commodity prices were much higher, are coming on line. The resulting excess capacity has added to the oil price collapse. Industry participants’ first response has been consistent with past price declines with moves to restructure operations and cut costs.

While cost—cutting is necessary to weather the storm, the industry has thus far been careful not to jeopardize long—term growth opportunities in the process, avoiding, for instance, the drastic layoffs of the past. The capacity to benefit from higher oil and gas prices down the road is widely recognized as a factor in valuing companies over time. In particular, the long—term value of good people is hard to overstate.

Past recessions show that indiscriminate layoffs, particularly of key technical workers, can hobble a company’s recovery when they are suddenly in short supply. While there are not many upsides to the current environment, companies should consider the strategic advantages of retaining and even recruiting key talent while demand is low and supply high.

What’s not in good supply, of course, is credit. A recent survey of the chief financial officers of oil and companies identified credit capacity constraints and limited access to new capital as their companies’ greatest financial challenges in 2009.

The plunge in commodity prices directly affects the credit lines of oil and gas companies. The senior credit facilities of oil and gas companies are usually structured around a “borrowing base” tied to the value of the companies’ oil and gas reserves. This value is based on the price deck or current forecast that the lender applies to the company’s reserves. If the price drops when the company is due for a periodic estimation of reserves under its credit facility, its line of credit will be tightened.

To mitigate this risk, when extending the loans, lenders often require the companies to hedge all or some substantial portion of their production at current market levels. But due to the prevailing economy and market conditions, these hedges themselves are often at risk due to the deteriorating credit quality of the counterparties.

As a result, most CFOs are convinced that the economic crisis will hinder their ability to extend bank debt or borrow money in 2009. In the past year, a quarter of the companies said they had significant delays or termination in exploration and exploitation projects with many companies simply lacking sufficient capital to fund the projects.

This obviously does not bode well for the critical challenge that each company faces in replacing its reserves. The problem is particularly acute for companies whose production is weighted towards gas, since those projects are often dependent on capital intensive infrastructure such as a pipelines and processing facilities.

One consolation of downturns that is often overlooked is the impact on reducing costs of production. Such reductions, which generally lag sector cycles by six to eight months, mean companies will likely get more bang for the buck in the second half of 2009. As with investment in human capital, now may be the time to think about procurement or even advance contracting to secure a position at the head of the line when the economy improves.

In fact, there is at least anecdotal evidence that some management teams are already looking beyond the near—term pain at how to position themselves for strategic growth.

An oil and gas CEO, when asked if the current state of the economy had dampened his usually voracious appetite for oil and gas deals, replied: “Not at all. I am hungrier than ever.” He understands that in a tough economy the best investment a company can make is in its core business, as long as it believes that the fundamentals of that business exceed its current valuations.

The long—term supply and demand picture certainly looks a lot rosier than the current one. Most international agencies monitoring global energy needs predict that over the next quarter—century the world will need between 60 and 80 million barrels a day of incremental crude supply. The top of that range is almost double today’s demand. This explains why many companies are pushing to green light capital projects even if the banks and financial institutions they rely on are not.

In looking to bridge the financing gap for long—term capital projects, the first place companies should explore is their own balance sheets. This is particularly true for the majors and larger independents, which have huge stockpiles of cash from years of record high commodity prices. For them, the credit crisis may be an opportune time to pick up smaller companies or enter new geographic regions and plays.

The drop in commodity prices has reduced values across the sector but small and middle market oil and gas companies have been hardest hit. This is because, unlike their larger counterparts, they are not vertically integrated in the supply chain and do not have any refining or retail units to offset the declines in their upstream divisions. With smaller balance sheets, they are also typically more reliant on debt or commercial paper conduits to finance their working capital needs.

Devon Energy, for example, has recognized this market disparity and is using it as an opportunity to strengthen its strategic position in key areas. In recent months Devon has acquired several smaller competitors as a way of expanding into new basins such as the Barnett Shale.

Other recent strategic deals include Shell Canada’s acquisition of Duvernay Oil for C$5.9 billion (US$5.86 billion), StatoilHydro’s acquisition of a 32.5% interest in Chesapeake Energy’s Marcellus Shale assets for US$3.375 billion, and BP’s acquisition of Chesapeake Energy’s Woodford Shale assets for $1.7 billion and a 25% interest in Chesapeake’s Fayetteville Shale assets for $1.9 billion.

The StatoilHydro deal deserves special mention for its strategic creativity. The deal was designed to compliment StatoilHydro’s existing capacity rights at the Cove Point LNG terminal, its gas trading and marketing organization, and its gas producing assets in the Gulf of Mexico. We believe that investments, like the StatoilHydro deal, which give companies greater reach and flexibility across the oil and gas value chain, are particularly attractive today.

But what if companies can’t find capital reserves on their own balance sheets to do these deals or, worse, what if their bank financing has suddenly become shaky?

One powerful strategy that we are advising clients to pursue with their lenders is a “communications offensive.” Even companies that are not now in need of additional capital or altered credit terms should be mindful of their relationships with lenders and begin treating them as true partners. This means making anticipatory disclosures of opportunities and problems and giving them more information than is called for the by the terms of the loan agreement, even if it is currently performing.

Informed lenders are often easier to work with and when caught off guard, in our experience, they tend to react badly. New money or forbearance, if it is forthcoming at all, may cost an arm and leg. Much better to keep the information channel freely flowing at all times.

What about prospects for new credit or workouts of existing credit with current lenders? While we can’t say it’s a robust environment, such deals are getting done. For instance, in a significant financing announced recently, Chesapeake Energy issued $500 million in long—term debt to reduce a credit line which it had maxed out to ensure sufficient cash to operate in case of further credit markets deterioration. While the Chesapeake deal was a positive sign, the overall market for bank deals is anemic and will probably remain so for the foreseeable future.

Without a bank option, many companies, especially those with a significant exploration portfolio, have sought capital from the public equity markets. But equity investors, though still active in the sector, are more cautious. Despite record oil prices in the first half of 2008, oil and gas issues, and the aggregate amount of money raised by them, were down significantly last year.

Many new issues in the oil and gas space trade below their issue price, and, in several cases, moves to the main market or proposed private placements have been postponed or cancelled due to market conditions. Although the situation has improved in recent weeks, it is likely to be some time before oil and gas companies have access to public equity markets on favorable terms.

As a result of these trends in the debt and equity markets, institutional, private, and strategic equity investors are becoming an increasingly important source of capital for oil and gas companies. Private equity funds have also become more visible in the sector. Kayne Energy Funds estimates that the amount of private capital available in the energy sector has risen from less than US$2 billion in 1998 to approximately US$24 billion in 2007. Private equity capital is available in a range of sizes, from small investments to multimillion dollar placements.

We also note that some companies, Chesapeake in particular, have recently sold volumetric productions payments (VPP) as another source of capital. In 2008, Chesapeake closed four VPP transactions totaling more than $2 billion. Unfortunately, as gas prices have declined so has the market and prices for VPPs.

Finally, another reason for hope, in the middle term at least, may be emanating from Washington. The Securities and Exchange Commission recently proposed a rules change that will allow companies to value their crude reserves on the basis of a 12—month rolling average, instead of the current lottery—like single—day fixing for the year. The new rules also allow companies to book reserves in the probable and possible as well as reserves from unconventional resources. This will significantly increase companies’ reported reserve base.

The impact will be good for industry borrowers and good for mergers and acquisitions. Although the change does not go into effect until Jan. 1, 2010, many commentators believe it should begin affecting the credit markets well in advance of that date.

About the authors

Shahid A. Ghauri is a partner in the Houston office of the international law firm Jones Day. His practice focuses on oil and gas law, project development and finance, international business transactions, M&A, asset dispositions, acquisitions of exploration rights, and joint ventures. He has a JD from the University of Houston and a BS and MS in petroleum engineering from the University of Texas.

Kathleen McLaurin is a partner in the Dallas office of Jones Day. She has more than 30 years’ experience advising clients in a variety of complex transactions with particular experience in the oil and gas industry. She has extensive experience in mergers, acquisitions, and dispositions involving publicly traded and privately held companies. She has a BA from Rice University and JD from Emory University.