Energy outlook 2016
Energy outlook 2016
ERIC SWANSON, BRYAN FREDERICKSON, GULFSTAR GROUP, HOUSTON
NEARLY A YEAR NAs demand growth has softened, supply and demand factors set the stage for near-term uncertainty and a potentially prolonged period of low prices. Energy traders and other finance industry professionals have generally declined to call the "bottom" for commodity prices or to speculate about when conditions will improve, as reflected in a forward oil curve that is essentially flat. It is within this environment that oil and gas producers and the companies that provide them with services and products must evaluate operating plans, as well as financial and strategic options.
Throughout the course of 2015, producers have come under increased pressure to be even more disciplined in capital spending. The focus on returns has become more important as the hope of a quick recovery in commodity prices has vanished. Producers have acted swiftly and decisively to cut capital expenditures, work with service providers to reduce operating costs and adjust drilling plans to focus on the most productive drilling areas. Funding for new projects faces extreme scrutiny and is dependent upon the economics of specific areas of any region. As a result of increased efficiencies, producers have found a way to make returns while sustaining production levels, despite a dramatic drop in the rig count. While the land grab and fracturing optimization was done in a $100 oil environment, operating efficiency coupled with improved well productivity are supporting operations in a $50 oil environment. If any sort of agreement has been reached within the industry, it is that companies facing severe earnings pressure or liquidity shortfalls should not count on a near-term market recovery to rescue them from these issues.
SIGNIFICANT UNCERTAINTY REMAINS IN THE UPSTREAM
While producers have adapted to operating in the current environment, M&A activity in the upstream space remains depressed. Volatility in the commodity price outlook has traditionally driven a wedge between buyer and seller expectations and inhibited their ability to reach acceptable deal terms. Despite more stability in oil and gas prices, the long-term outlook remains depressed with crude and natural gas not reaching $50 per barrel and $3.00 per MMbtu, respectively, until 2017. Producers would prefer to retain producing assets, particularly if they hold acreage with derisked drilling opportunities, rather than part with an asset through a sale at this point in the cycle. As a result, midstream and infrastructure assets will likely remain targeted for sale as valuations remain more attractive relative to upstream assets. Near-term property sales are likely to be driven primarily by forced asset divestitures, geographic exits and distressed company sales. Owners may consider acquisitions by larger competitors to realize benefits of scale and improved liquidity while retaining equity ownership to bridge a valuation gap and preserve upside potential.
While the market expected a wave of acquisitions led by healthier, better-capitalized companies, such activity has largely failed to materialize. Partially due to billions of dollars of public capital raised in 1H-2015, many companies have liquidity to extend the operating runway for the next 12 to 18 months. The fall bank redeterminations of reserve-based credit facilities have proven not to be the catalyst for activity that many expected and resulted in only modest borrowing base cuts. However, as commodity hedge benefits are depleted and public capital markets become choppy, reducing access to lower-cost capital, more M&A transactions may be on the horizon as corporate distress increases. "Non-core" assets have generated interest from smaller producers, but seller expectations are rarely met. As producers continue to prioritize limited capital to the highest rate of return projects, underfunded assets that are unlikely to compete for capital in the foreseeable future in larger portfolios may be targeted for sale. Higher quality assets that are part of a regional exit are more likely to test the market in 2016. At this point, healthier companies will be better positioned to seize the opportunity to consolidate market share and enter via acquisition. Abundant private equity capital is available to support these transactions, as investors consider the current environment a buying opportunity after several years of heady valuations.
Reluctant acceptance of the current environment is expected to dominate the operating outlook for the foreseeable future. Drilling activity will continue with a laser focus on cost, efficiency and returns. Drilling of core areas will likely continue at a moderate pace, while the inventory of drilled but uncompleted locations is depleted. Despite reduced operating costs, margins continue to be squeezed as attractively priced hedges roll off, resulting in debt metrics likely ratcheting up in 2016. Many companies find themselves in true financial distress when they try to maintain staff levels, unprofitable locations or service lines beyond the time when it is evident that underutilization is draining the business of much-needed cash. This is not meant to suggest that this is the new normal and things cannot improve, but it would be overly optimistic to set business strategies that are reliant upon improvement in commodity prices.
MIDSTREAM GROWTH OUTLOOK CONCERNS
While the midstream space held up better than upstream and oilfield service companies during the first half of 2015, master limited partnerships (MLPs) have moNearly a year and a half after oil prices began their march from over $100 per barrel to current levels hovering near $40, no confident consensus has emerged on when the market should expect a recovery or even what such a recovery might entail. re recently been negatively impacted with investors focusing on the issues challenging producer growth, reflected in the Alerian MLP index yielding near its highest levels since July 2009. The pace of equity issuance and the number of companies seeking initial public offerings has dropped dramatically. Similar to upstream spending trends, MLP growth capital spending is expected to decline in 2016 and 2017.
Over recent years, many companies formed MLPs after receiving private letter rulings that added income from non-midstream activities. The space had seen steady growth in non-midstream MLPs that focus on segments such as upstream, oilfield services, refining and shipping. Oilfield service examples include service providers such as water haulers and developers of infrastructure, such as saltwater injection wells. MLPs adhering more closely to traditional midstream activities, such as pipeline transportation of oil and natural gas, are best-positioned within the current market environment, though volume and price pressures will be a concern. MLPs containing a greater proportion of upstream-derived income are likely to face similar issues as general oilfield service providers.
With margins squeezed for upstream producers, continue to watch for infrastructure asset sales and tariff renegotiations to bolster producer returns in higher cost regions. Such changes may have a corollary effect of spurring more upstream M&A activity. Midstream M&A activity may remain focused on simplifying organizational structures or abandoning the MLP structure to reduce the cost of capital. MLP strategies that are supported by future drop-downs are expected to be rewarded, as many analysts believe the segment has been overly punished and consider the stronger MLP names to be compelling investment opportunities.
DOWNSTREAM WEATHERING THE STORM
Refineries and petrochemical companies benefiting from low crude prices, with no indication of near-term price increases, should continue to perform relatively well. According to the Energy Information Administration (EIA), Texas Gulf Coast refineries represent nearly 30% of US crude refining capacity. While capacity has increased, the absolute number of operating refineries has remained stable, indicating that capacity increases are the result of significant capital projects and upgrades occurring at existing refineries.
US capital spending across petrochemical, refining and gas processing is projected to be up over 20% in 2015 and in excess of $26 billion. The prime beneficiaries of this expansion will be engineering and construction companies, fabricators, testing, inspection and certification businesses. With so much pressure on the upstream segment, private equity groups and acquisition-hungry corporations are increasingly turning their attention downstream. Much of the activity required to support ongoing operations of refineries is mandated by regulation, providing the guarantee of recurring revenue for providers of those services.
EVOLVING CAPITAL ENVIRONMENT
Traditional banks are under substantial pressure from federal regulators to trim energy industry exposure, regardless of the perceived quality of individual loans. Many banks are effectively prohibited from new lending, even to companies that appear to be strong borrowers. Further, shareholders in public financial institutions that fall outside the regulated banking umbrella are likewise encouraging reductions in oil and gas exposure. Management teams need to view their lenders' behavior through this prism and not be surprised by lending decisions that may not seem rational in a pure business sense.
Banks do not, however, want to take direct ownership of companies or assets through foreclosures and are therefore potentially more willing to negotiate extensions and restructurings with distressed businesses. Bank portfolio managers are well aware that liquidating assets in the current price environment means locking in loan impairments at a low point in the market. In addition, if a company borrowed money based upon substantially higher oil (or other asset) prices, selling those assets may leave the bank in a worse position with respect to the ratio of remaining outstanding loan funds to collateral asset value. Unless a company is rapidly burning cash, limited downside exists from granting forbearance periods and allowing borrowers the opportunity to optimize operations, seek external capital or attempt to take market share from competitors.
Fortunately, billions of dollars of private capital has been raised by investment groups to take advantage of the current environment. The early thesis was that private equity dollars would be deployed to acquire attractive assets at low prices from companies that needed immediate liquidity. However, such sales have generally failed to materialize thus far and most of the available cash remains on the sidelines. Capital is available for businesses that have stabilized and have reasonable visibility into near-term, development opportunities with healthy returns. This capital has continued to migrate from acquisitions to balance sheet improvement. These investors are seeking opportunities to invest "rescue capital" into businesses to provide liquidity, repay senior debt (potentially at a discount to par, depending upon the financial health of the borrower) or fund consolidations. Investments are likely to be structured as some form of equity in order to minimize interest and principal payments that consume valuable cash flow. Existing shareholders would likely be diluted or have new, more senior securities in the capital structure, yet retain the opportunity to participate in a market recovery and avoid the forced shedding of assets at unfavorable prices. Ultimately, it is better to own a smaller piece of an appropriately capitalized business than a larger stake in a bankrupt one. Selling assets should be a last option as cash flow is weakened, loan-to-value ratios are damaged and paper investment losses are realized.
The general advice to business owners and decision-makers is to engage in early and frequent discussions with lenders. To preserve a constructive relationship, borrowers need to be forthright regarding the current state of the business and present an actionable plan. Initiating discussions with non-bank, capital providers can help preserve lender confidence that management has such a plan in place should financial conditions deteriorate. A passive approach in the current environment may invite further lender involvement and oversight, removing control of the situation from management's hands.
CONCLUSION
Looking forward, the outlook for 2016 remains cautious as the industry works through this downcycle. The industry has reigned in the momentum of capital programs in 2015 and may further reduce spending in 2016 as efficiency and returns dominate. Attractively priced public market capital may be less readily accessible, but private capital remains available for balance sheet repair and the pursuit of opportunistic M&A. While a continued lack of urgency to sell assets persists, those that can survive and take advantage of unique opportunities to acquire, should be best positioned to benefit from a recovery.
ABOUT THE AUTHORS
Eric Swanson is a managing director at GulfStar Group. He has more than 16 years of investment banking and corporate finance experience that includes mergers and acquisitions transactions, debt and equity offerings and corporate finance advisory. He joined GulfStar from Morgan Stanley's investment banking group in Houston, where he spent eight years focused on the E&P segment of the oil and gas industry.
Bryan Frederickson is a managing director at GulfStar Group. He has 18 years of investment banking and corporate finance experience that includes execution of merger and acquisition, financing, venture capital placement, recapitalization and restructuring transactions.