Surprises, vulnerabilities, and options
EDITOR'S NOTE: Spring redeterminations are on the minds of many throughout the oil and gas industry. Skadden partners Ron Meisler and Frank Bayouth-oil and gas focused restructuring partners based in the firm's Chicago and Houston offices, respectively-answered questions about the outlook for spring redeterminations and the options available for distressed oil and gas companies.
OIL & GAS FINANCIAL JOURNAL: The 2015 spring and fall redeterminations did not see drastic reductions in borrowing bases as many were expecting. Will the 2016 redeterminations be different?
Prior to the 2015 spring and fall redetermination cycles, analysts and observers of the oil and gas industry forecasted severe borrowing base reductions across-the-board. However, counter to prevailing expectations, most borrowing base reductions in the spring 2015 cycle were fairly modest. Notwithstanding the drastic drop in commodity prices, it appears that as a general matter, lenders exercised moderation and opted to wait and see if the industry would rebound. Likewise, in the fall of 2015, lenders continued to stay the course and once again avoided severe or sector-wide borrowing base reductions. Indeed, more than half of the E&P companies subject to redeterminations had their borrowing bases re-affirmed or increased in the fall 2015 cycle. In those cases where the borrowing base was reduced, as a general matter, the reductions were smaller than anticipated, akin to the spring 2015 cycle, averaging about 19%. Nevertheless, during that period, many companies raised capital and used a portion of the proceeds to reduce their RBL balances, which was a mitigating and noteworthy factor regarding the modest 2015 redeterminations.
With the 2016 spring redetermination cycle upon us, it is increasingly clear that the severe reductions analysts and observers have been predicting will finally materialize. There are several factors contributing to the more severe redeterminations. For one, as the downturn in commodity prices has endured longer than expected, traditional reserve-based lenders-typically large, highly regulated banks and other financial institutions-are facing increased pressure from their regulators to reduce their exposure to the sector particularly to the more troubled companies in the sector. In addition, many of the hedges that were put in place when oil prices were high and mitigated the initial impact of low oil prices during 2015 have begun to roll off and will continue to do so in 2016 and beyond. Furthermore, most E&P companies significantly curtailed drilling and completion operations in 2015 and early 2016 to preserve liquidity. Although successful in preserving liquidity in the near-term, the reduction in drilling activity can result in even lower levels of proved reserves, which materially impacts the borrowing base.
OGFJ: What have you observed from the spring redeterminations so far? Has anything surprised you?
For the aforementioned reasons, the redeterminations for this cycle thus far have been much more severe than the last two cycles, with some companies suffering very substantial reductions. Given the relative leniency of lenders in the past two redetermination cycles and the failure of oil prices to rebound for over a year, the increased severity in the redeterminations seen in the early stage of the spring 2016 cycle is expected to continue, and it is likely that other similarly severe reductions are to come in many cases.
OGFJ: Who in the oil & gas sector is most vulnerable to borrowing base reductions and why?
The companies most at risk for a borrowing base reduction appear to be those with the least ability to mitigate the liquidity drain as a consequence of such borrowing base reduction. The location and quality of the borrower's assets are also important. The economics of each oil and gas producing basin are different. Indeed, even within a basin the economics can vary dramatically. As a general matter, companies with activities concentrated in places with relatively high breakeven prices are more at risk for a negative redetermination. In addition, lenders will give great weight to the borrower's overall financial condition, including its operating results, capital structure, forward-looking business plan, and strategic options, when making borrowing base determinations.
OGFJ: How should E&P companies manage an impending redetermination?
A distressed E&P company that is faced with a potential negative redetermination should consider reaching out to the lending group prior to the redetermination. Keeping the lines of communication open and involving the lending group early in the process in an effort to preserve the relationship may be helpful in reaching a compromise.
OGFJ: What are next steps and options for companies that do experience a negative redetermination?
A reduction in borrowing base may create a borrowing base deficiency. A deficiency occurs when the amounts outstanding under the facility exceed the borrowing base. When a deficiency occurs, the borrower must either repay the deficiency amount within a specified period or add additional assets to the borrowing base to increase the valuation.
When faced with a potential deficiency, E&P companies with sufficient liquidity and time may be able to negotiate a comprehensive restructuring out-of-court. Once negotiations with the lending group are underway, there are creative solutions worth exploring.
Those distressed E&P companies with sufficient liquidity and proper planning may also choose to follow the lead of those companies which have filed prepackaged or prenegotiated chapter 11 proceedings leading to fairly short chapter 11 proceedings, including Milagro Oil & Gas, which filed in July of 2015 and had its plan confirmed in October of 2015, and Swift Energy, which filed in late December, 2015 and confirmed its plan in late March, 2016.
Other strategies include taking on first-, second- or third-lien secured debt, issuing unsecured notes, exchanging unsecured notes for new secured debt at a discount, buying back notes at a discount, issuing equity, and selling noncore assets. However, as prices remain depressed, the viable options become more limited.
OGFJ: How can distressed E&P companies balance their immediate liquidity needs with their ongoing relationship with their lending group, taking into account their long-term liquidity needs as market conditions rebound?
Choosing the best course of action depends upon the company's financial condition, capital structure, and expectations for future commodity prices. That said, if a distressed E&P company knows a negative redetermination is imminent, it should not wait until its options are limited to begin evaluating strategic alternatives or to begin discussions with the lending group. Those E&P companies that engage restructuring professionals to assist them in evaluating their alternatives and developing a restructuring plan will maximize their chances of resolving issues out of court or initiating a quick and cost-efficient prepackaged or prearranged chapter 11 filing, both of which may permit them to increase liquidity and minimize disruptions, if any, to their business operations, and to minimize the risk of a longer term free-fall bankruptcy or liquidation.
ABOUT THE ATTORNEYS
Ron Meisler is a corporate restructuring partner in Skadden's Chicago office. Meisler represents clients in complex transactions involving business reorganizations, troubled company M&A, debt restructurings and recapitalizations, distressed financings, and alternative and special situation investments. He represents troubled companies in all stages of complex restructurings, purchasers of and investors in distressed companies, and lenders to and creditors of troubled companies. Meisler received his BA, MBA and JD from University of Michigan.
Frank Bayouth is a corporate partner and head of Skadden's Houston office. His practice concentrates on corporate and securities matters, with particular emphasis on mergers and acquisitions, private equity transactions, corporate finance and corporate governance issues. Bayouth represents public and private companies, private equity firms and hedge funds, as well as investment banks and financing sources in a variety of US and international transactions, primarily in the oil and gas sector. Bayouth received his BBA from Texas Tech University and his JD from University of Texas Law School.
About the Author
Mikaila Adams
Managing Editor, Content Strategist
Mikaila Adams has 20 years of experience as an editor, most of which has been centered on the oil and gas industry. She enjoyed 12 years focused on the business/finance side of the industry as an editor for Oil & Gas Journal's sister publication, Oil & Gas Financial Journal (OGFJ). After OGFJ ceased publication in 2017, she joined Oil & Gas Journal and was later named Managing Editor - News. Her role has expanded into content strategy. She holds a degree from Texas Tech University.