Predicting energy defaults
O&G COMPANIES STRUGGLING TO RETAIN OR REGAIN THEIR FINANCIAL HEALTH
JAMES H. GELLERT, RAPID RATINGS INTERNATIONAL, NEW YORK CITY
ENERGY DEFAULTS increased in 2015 more than any other sector, and as we begin 2016, the convergence of volatile capital markets, higher interest rates, low commodity prices, and the return of credit differentiation will usher in more bankruptcy filings and forced asset sales. If these challenges aren't enough, the financial health of swaths of energy companies, which has been deteriorating for close to three years, will continue to struggle mightily.
This is bad news for firms managing risk of energy companies, as well as energy companies managing counterparty risk of other energy companies. Unlike most industries, energy companies take on risk of many others intra-industry. Buying from, selling to, and trading with others in the same industry creates a concentration of risk where factors affecting one's own company are affecting one's principal counterparties as well. In this way, an energy default ripples through the industry in unparalleled ways.
Fortunately, as a result of the global financial crisis, most corporations are taking counterparty risk more seriously and broadly considering it core to enterprise risk management. Customers, suppliers, vendors, JV partners, and others now need to be evaluated and managed on a regular basis, and risk professionals are grappling with how to implement more systematic and comprehensive risk management programs.
RATES AND CAPITAL MARKETS REALITY
The Fed's recent rate hike, while expected, is a positive for market directional focus. With interest rates historically low for such an extended period, institutional investors sought yield and competitively vied to lend to, and invest in, companies down the credit spectrum. This yield chasing meant companies of suspect financial health had easy access to capital which was used, amongst other things, to refinance debt maturing in 2015 and 2016. Low interest rates and somewhat aggressive and indiscriminate investing effectively kicked the refinancing can down the road into 2016 and out to 2019 and beyond.
As rates rise over time, though, more credit differentiation will return to the market and expose a lot of weak companies. Many will not be able to refinance again. And those that can finance will do so at higher rates, increasing their costs of capital or perhaps requiring security, encumbering assets. Those that can't finance will default, be restructured, taken over by private equity, bought by strategic acquirers, or descended upon by distressed hedge funds to uncertain ends.
What does all this mean? It means we're entering a period of intensely complicated risk management for energy companies.
For those implementing improved risk management processes for 2016 and beyond, it's critical to acknowledge that there will be defaults. It's also important to recognize that companies don't default overnight. With the rarest of exceptions, companies deteriorate over time and trends in their weakening can often be seen if a broad enough perspective is taken.
Regardless of what risk management tools and signals energy financial professionals use, it's imperative they take a portfolio approach as an investor would; evaluate as broad a group of counterparties as possible on as regular a basis as possible, looking for the measures that provide early warning of deterioration. It's also critical to not be over reliant on any one individual metric, such as debt/equity ratios, as a myopic view can give false comfort and other signs might be missed.
How do we know which energy companies are stronger and weaker and where are these companies headed overall? We can start by looking at common signals of those who have already failed. As the CEO of a ratings agency that assesses 40,000K+ public and private companies based on 73 ratios across 12 million company years of financial data, I can share our data and perspective.
Most of the energy companies that filed for bankruptcy in 2014 and 2015 had a poor Financial Health Rating (FHR), our 0-100 metric of risk where 100 is the best, and were categorized as High Risk or Very High Risk leading into their defaults.
The failed companies had distinctly different profiles than non-defaulters in our energy coverage universe and showed signs of these deteriorating elements for an extended period:
Median FHR at bankruptcy was 21.5 compared to a score of 46 for all energy companies under our coverage. The company with the lowest FHR score at bankruptcy was Allied Nevada Gold Corp., with an FHR of 13
Median current ratio at bankruptcy was 0.501 compared to 1.32 for all energy companies. For bankrupt companies, the current ratio has been declining at an average rate of 32% over a two-year period compared to a 1% rate of decline for all energy companies. The company with the lowest current ratio at bankruptcy was Kior Inc. (0.0187)
Quick ratio at bankruptcy was at 0.41 compared to 1.13 for all energy companies. Quick ratio has been declining at a rate of 36% over a two-year rating period, compared to only 1% for all energy companies. The company with the lowest quick ratio at bankruptcy was Kior Inc. (0.01)
Median debt/equity ratio was 151% at bankruptcy, which declined from a prior year D/E ratio of 186%. The company with the highest D/E ratio at bankruptcy was Milagro Oil & Gas (1092%)
Interest coverage ratio for bankrupt companies was at -5 compared to -0.55 for all energy companies under coverage. The company with the lowest interest coverage ratio at bankruptcy was Afren Plc (-62.00).
Return on Assets at bankruptcy was -35% compared to only -2% for all energy companies under coverage. ROA has been declining at a rate of approximately 100% over a two-year rating period. The company with the lowest ROA at bankruptcy was Kior Inc. (-571%)
Return on Equity at bankruptcy was -77% vs 0.3% for all energy companies under coverage. The company with the lowest ROE at bankruptcy was Afren Plc. (-1048%)
What's clear from this is that there are identifiable characteristics of weakening companies that ultimately have failed, and these early warning signs must be a focus for energy professionals in 2016 and beyond. While historical credit analyses look at only a handful of metrics such as debt to equity ratios, and possibly market signals like credit default swaps or bond prices and ratings, these aren't sufficient on their own, and may, in fact, be misleading. As seen from the above data, there are many other elements that can signal deterioration and inform risk management decision making.
The US high yield bond market, of which energy companies make up approximately 15%, was the worst performing asset class in 2015 and became highly volatile in the second half of 2015. Equity market volatility, particularly in energy sectors, is high and will continue to be so in 2016. Risk management cannot rely on these traditional signals going forward.
Furthermore, we estimate that approximately 80% of energy companies' counterparties are non-public. This means there aren't public market signals to review and also highlights another critical component of more sophisticated risk processes - a systematic approach to analyzing private counterparties. More than ever before, private companies understand the need for financial disclosure to commercial counterparties and 2016 will be a watershed year for this type of transparency. We estimate a threefold increase in our clients' evaluation of private companies in 2016, after a doubling in 2015.
It would be hard to recall an industry as large with as tricky a confluence of factors working against it as energy faces in 2016. There will undoubtedly be some bright spots and positive surprises, but the overall picture is bleak. A tougher funding environment for companies of strong and weak financial health will mean risk professionals must be more prepared than ever before. More than ever, energy professionals need to monitor their portfolios of counterparties systematically and be able to dive deep into any individual credit, at any time. The overall decrease in energy companies' financial health is a backdrop that should make all risk professionals with energy exposure highly attuned to the challenges of the year ahead.
ABOUT THE AUTHOR
James Gellert is CEO of Rapid Ratings International, a provider of quantitative financial health ratings and risk management solutions. Prior to Rapid Ratings, he held leadership positions at Howland Partners, Deutsche Banc Alex Brown, UBS, and numerous technology and information-focused companies. Gellert has testified before the US Senate and House of Representatives on multiple occasions about topics such as ratings industry reform.