PJ SOLOMON's George Ward and Tero Jänne discuss what’s next for the Energy sector as it grapples with historically low oil prices and plunging demand amidst a global pandemic.
PJ SOLOMON's George Ward and Tero Jänne discuss what’s next for the Energy sector as it grapples with historically low oil prices and plunging demand amidst a global pandemic.
Tero Janne: 0:06
To be a survivor through the turmoil in the energy sector today, having a coherent plan to minimize costs and live within your cash flows is a must.
George Ward: 0:20
People should really be acting, you know, sort of immediately and making choices and controlling their destiny.
George Ward: 0:31
Thank you for joining us today. I'm George Ward, Managing Director in the Energy practice at PJ SOLOMON, and I run the group in Houston.
George Ward: 0:39
Joining me today is Tero Janne, a Managing Director in PJ SOLOMON's Debt Advisory & Restructuring practice. Talking to you today from my home, probably as a lot of people are, with social distancing today.
George Ward: 0:50
So we'll be laying a little bit of a backdrop for the energy sector today and alot has happened in the sector over the last couple weeks. And, we have seen a significant movement in crude prices. You know, as we sit here today and look at the price curve for crude and its at $29 and you don't even see forties until really 2024, so the back of the curve really hasn't moved up much. You know how do we get here, right? You go back, you know, about 30 days and think about some of the events that took place. You had OPEC and Russia disagreements and break from their production cuts. And coupled with that, you had Covid-19 pick up some progress around the globe and, you know, bring with that significant demand destruction on the oil side really to the tune of something about 20 million barrels a day. So, because of where the estimates are currently you bring both of those factors into play and we have significant movement in crude prices through the last 30 days. We've seen a number of producers react to that movement in the crude price with capital expenditure cuts through 2020-21; pushing large projects off, cutting dividends, really trying to react quickly as crude prices were coming down. But certainly this is a significant event for the industry, though it is quite a different event that what we've seen in the past. We think about the financial crisis of 2008, the crude price drop in 2015. This one certainly feels a lot different. Tero, when you look at what's going on in the market today, you know what do you think that the differences are? What do you think some of things will see that will be different from what we saw in 2008 and 2015 for the sector?
Tero Janne: 2:49
Yeah, it's really interesting thinking about the sector, and you know what's really happening the last 30 days in part has probably been in process for sometime before that, but just has gotten just rapidly accelerated. I do look at the world a lot from the perspective of what has happened in the sector during the last few periods of upheaval, you know, you mentioned the financial crisis and the 14-16 upheaval as well, and there are certainly differences and some similarities to the two. I always remember the 08-09 time frame really for the fact that there was a severe lack of access to capital and credit and that that was not just specific to the sector, but just very widely around the economy in general. But, I think the other macro actor then was that the unconventional drilling segment was really in its early stages and the impact of US production on global prices was minimal or less at that stage, when you compare that to what happened that in the 14-15-16 sector upheaval, from the credit perspective, it was very different. Access to capital was widespread and the upheaval that was occurring in the energy sector was really sector specific, and the economy itself generally wasn't in good shape. But the difference from the production perspective, obviously was that the unconventional drilling component to overall production had significantly grown and the US had become a much more significant producer overall to the globe with an impact on pricing. When you look at today, and we're obviously in very early innings of the sector challenges that are being faced today, you do see similarities to the late 09 timeframe from the perspective that the access to credit again is very constrained and the impact of US production on overall pricing has grown even further from the period of the 2014 to 16 upheaval.
George Ward: 4:55
Even before Covid-19 was something we were talking about, our sector was really starved for capital, right? When you think about the US energy sector and looking back, really, over the last several years, you know, capital has been tight in the sector and it was getting tighter. And you could really feel that putting some pressure on the space really coming into the end of 2019. You can certainly look at recent performance, obviously just given the quick move in crude, how that has affected energy stocks here. But if you even go back two years, and think about what that picture would be. And I think the S&P 500 today is down maybe 5% if you take a look back two years, whereas the energy sector is down 75%. So the energy sector is coming through, really years of under performance, really almost from the start of 2016 period. That's having, obviously, an effect on the space and we really felt that coming into 2019; limited access to capital, the inability to IPO into the marketplace, really sort of changing M&A dynamics and valuations, right? People trying to monetize investments and move companies forward were just facing a lot of challenges, and you sort of you know, take that into account and then bring in Covid-19 and it's really sort of a perfect storm of difficulties and challenges for the energy sector. At the end of 19 we were seeing seeing that with processes, M&A processes, that we were either participating in or running from a sell side perspective that you know if you went back a couple of years you would get, you know, really, a substantial amount of bid activity and then coming in the end of 19 especially, you were seeing that that activity at a much, much lower level. Oftentimes, people are seeing processes where they were trying to monetize assets and really ended up with no bid or no bid that they were willing to take on those assets. Then you roll that forward to where we are today. It really creates an issue with trying to monetize assets in the marketplace.
Tero Janne: 7:04
I think to that point, you know you think about also what I think about every day is the corporate balance sheets. And what are the tools available to corporates to address their balance sheets and liabilities within different times in cycles within the sector and you know, clearly when you think about when there is access to capital, as there was during the 14 to 15 upheaval in the sector, many corporates took different views as to how to address and took different strategies to address their balance sheets. So you saw [inaudible] changes, term outs of RBL capacity, there were new second lien financings. And there were creative recapitalizations that came with new money that coupled [inaudible], discount exchanges and equitizations of components of the balance sheet, but all driven really by new capital coming in to help the corporate continue to operate and continue to grow production. When you don't have the access to capital as you see today, that set of tools, that breadth of strategies that companies took over time and in stages to try to adjust their problems really isn't there, and it really creates a very different fact pattern to try to address one's balance sheet and think about how do I get from an overlevered, tight liquidity position to a better place than I am in today and you know there the backdrop really goes back to the financial crisis, and one of the things that certainly is very different today than during the financial crisis as we look back is that you know, the financial crisis ultimately was a relatively short duration of upheaval. And, here, as we sit here today, we're totally just in the early innings, with very little visibility as to the duration of this downturn. But we do know, for example, that many of the investors who came in to rescue capital structures in the 14 and 15 sector upheaval are likely not there in the same level or magnitude today.
George Ward: 9:12
We, you know, see that firsthand with what we do. And so as you think about the underperformance in the energy sector, really from that 15 to 16 timeframe, a lot of those players who came in and filled that capital need are seeing under performance on their investment. We are seeing you know, some new sources of capital into the space and they have been doing so really over the last couple of months. We are seeing some capital come into that void, if you will, but certainly not at the pace that we had seen in the 15 downturn. I mean, when we look at the sector, the energy sector, its something we talk about often, is where they are in their life cycle- the shale revolution, if you will in the US. What inning are we in? And we had alot of dialogue on this and certainly going on in 2019 and figured-hey, we were in the early innings for the last, you know, whatever period you wanna pick-10 years-where there was a substantial sort of a land grab going on and a lot of capital was coming into the space, alot of teams were being formed to sort of go out and, you know, develop positions in which to run their operations on and acreage positions and develop those acreage positions and maybe prove them up and flip them, but stay relatively small operators. And the thing that we were seeing really happen a lot here, and it's been talked about a lot over the last few years, is the industry's changed right? The investors the last couple years been saying, you know, it's not about growth anymore. It's really about cash flow and show me the cash flow and a lot of the entities that were formed and the [inaudible] collecting positions weren't really formed to do that, weren't really formed to be operators and we've seen that shift in the energy market from maybe what were the first sort of 3 or 4 innings to innings 5 and 6, where you're going from companies that were going out building positions and growing for growth's sake to companies that had to be larger, better operators and start delivering cash flow and profitability on that investment.
Tero Janne: 11:19
And that's really across the board. What new investors or existing investors putting in incremental capital to corporates are looking for, meaning that return on investment, are positive cash flows from those investments.
George Ward: 11:38
Yeah, absolutely. And you know, actually, the challenges with the price check where it is now, that's a little harder to achieve. Certainly, most of folks that have production are hedged and find themselves somewhat protected by the price decline here, at least over the relative short term period, maybe 2020 and part of 2021. But with the price not getting above, I think 42 in 2024, certainly companies now are looking at their situation trying to figure out what moves they should be making to improve their efficiency. Their operating efficiency, cut G&A costs and really start prolong their runway here until we see better commodity pricing. You know, right now we're having a lot of conversations with some of the smaller corporate folks that certainly could benefit greatly from a combination. And through you know, G&A savings again, operational efficiencies, diversification of their positions and their operations overall, I mean, just to put some really rough numbers on, I mean, some of the companies we're looking at are relatively equal in size and would probably merge as equals, and you think about their G&A budget and rough numbers, they may both have $100 million in G&A annually, and that's a bit rich. I think they could cut, and we look to cut 20 or 30 million out of that on their own. But you put two companies together and their G&A budgets again, are probably around 70 or 80. So that's, $100 to $120 million that could drop the bottom line. It's a really substantial savings and something that a lot of folks are looking at doing right now.
Tero Janne: 13:14
When the sector went through its upheaval in the 14 and 15 period and you saw a number of corporates restructure or recapitalize their balance sheets, that recapitalization or restructure of the balance sheet was not coupled at that stage with any kind of addressing, or meaningful addressing, of cost structures. A number of companies, for example, went through very quick dips into a Chapter 11 process and exited bankruptcy and then only subsequently started to address through the lens of the new investors, the cost structures. And obviously I think, as we think about the new investors coming in going forward, I think they're gonna, you know, look even more carefully at cost structures and think about how their new investment creates return on that capital. Given not only what's happened from a pricing perspective, but also there is likely a further ability to rationalize costs, whether through consolidation or just elimination of overhead, given where drilling activity is likely gonna be in the near term.
George Ward: 14:18
Yeah, absolutely. We're definitely, you know, moved to more efficient operations and its something that everyone's looking to do and we're seeing a lot of conversations revolving around that. When I look at the industry right now and you think about how you progress forward through it just in the in the environment that we're in, you know, one of the things that is interesting is sort of how you how you work through, right, you're debt stack. And how you buy yourself some time here in the space. If you're one of the smaller producers and someone that find themselves a little bit in a tighter position on liquidity and certainly as we're having conversations with folks there's certainly alot of flexibility and creativity that are going into liquidity solutions to get that time and to get that runway. I mean, what we're seeing on the M&A side right now, we're on some processes that are in bankruptcy, and part of 363 sales, is that the prices that one could realize right now for their assets is really just at a very low level. Right? So, uh, unable to really recover a lot of those costs or really impairing the debt levels. So I think part of the game for folks right now in the space certainly these are, the smaller folks, the ones they're going to be maybe a little more inefficient than some larger players is, how do you buy that time? What do you do with the banks and with the noteholders to get as much time as you can to hopefully get better commodity pricing on down the road? And we've certainly spent a lot of time having those conversations.
Tero Janne: 15:52
I think in terms of that strategy for most corporates it really comes down to two critical items. One is having a pathway to preserve your own liquidity position is first and foremost in my mind and then second, you know, as corporates think about having to have difficult conversations for their economic stakeholders, whether those are lenders or equity owners having you know, a coherent plan, a strategy to kind of couple the components we've talked about: rationalization of costs, ability to demonstrate an ability to live within one's cash flows, really are critical components to going to those constituents and getting the positive type of response that is necessary for that corporate to get whatever they need whether it's an amendment or a waiver or other relief from their lenders, for example, because obviously every lender out there is is getting these requests from a wide variety and number of other companies as well. And so being able to to articulate and demonstrate a coherent strategy likely puts that corporate, you know, in the top quartile of dialogue with its economic constituents versus going there with with an ask that's not structured around something that the lenders also can take to their own committees for support. George, how do you think buyers today...I guess primarily private equity or financial buyers are looking at the sector today? I mean, obviously, I understand the notion of consolidation from a corporate perspective, but are financial buyers active in the market or do you see them being active in the market in the near term given the upheaval?
George Ward: 17:45
Well, I think a lot of happened really too fast here, you know. Its just been a two week period. There are a lot of the funds that have been active in the space and funds that haven't been acting this space that we've had conversations with and that clearly want to put money to work in the sector now, seeing it is a great buying opportunity. Many of them have a portfolio of energy companies and certainly need to keep some of their capital around to support those entities, but a lot of those financial sponsors are looking to make investments at this time. I do think we need some stability in the market before they will put those dollars to work. And I think we need some visibility on where we think commodity prices are going to shake out, and we don't have either one of those. Right now, thevmarket continues on all levels to be highly volatile, and I think we need more transparency on where production is going to go, where the cuts are going to come from and what Covid-19 is going to do with the demand side. So again we get a clearer picture on where future prices, you know, may go on crude and on natural gas, so you know we're not there at this point, but there's certainly a large number of players who, you know, we believe will be bringing new capital into the space to make new investments and also facilitate some consolidation and mergers.
Tero Janne: 19:10
When I look at what the sector from the credit lens perspective, there's really, you know, in the months of April, three dates that come to mind. One is obviously one that we just passed, which was April 1st, when term loan interest was due; April 15th when you have coupons for corporates in some instances coming due, and then as we go to the back end of the month and get closer to May 1, first you have the borrowing base. What are you hearing from the RBL community in terms of how supportive of existing corporates will they be in terms of those borrowing based re determinations given fact that in large degree from any corporates that's their primary source a liquidity?
George Ward: 19:59
Yeah, it's a good question, and I don't think there's a set strategy yet from the RBL lenders. It is really you know, to my point I made before on the M&A front, I think really fluid right now. Again, we had a lot happen here so quickly that people are still trying to figure out what the right strategy is that that goes the first lien lenders, the RBL lenders, the banks as well. Certainly these are not assets the banks want to own and operate. So, our assumption is, and we're hearing that the banks there's going to be flexibility and creativity put the work here to provide some leniency, some runway for certain names, there also will be some credits where you know that that will not be the decision or the right path for the lenders. and they probably will be less supportive or provide no support, depending on the company, the company's assets and really, you know, points I think you've made before, sort of what is their cash burn, right, Really? So if you provide runway to, them are you just sort of creating a larger issue down the road for yourself,
Tero Janne: 21:07
I would imagine just on that point on the RBL lender community, and you know, obviously that they're working through their own level of uncertainty and thinking about price decks and potential impairment that you know if there is space within the capital structure that will be first addressed by third party sources of capital, that it would be trying to step in to the top of the capital structure and perhaps be replacement lenders for certain RBL institutions who may not want to continue to provide access to capital to corporates.
George Ward: 21:41
We've seen a fair amount of interest again from some of the new capital coming in now to take that role and have an interest in buying one off RBL risk as well as portfolios of RBLs. Those conversations are taking place and we expect those transactions to happen again. I think just given the volatility seen in the space for the last few weeks, it's been tough to get one of those deals over the finish line. But we do expect to see new capital to come in and certainly take some of this first lien risk off the banks' balance sheets. Moving forward and from the US producer side, I don't think a lot is going to change. Certainly there has to be some consideration to overall cuts and demand and being able to respond to something like Covid-19 that will need to be put in place, sort of measures and actions that people need to think about on a go forward basis,
Tero Janne: 22:32
And it seems like the sector ultimately will emerge more consolidated than it has in the past out of this turmoil.
George Ward: 22:39
That was happening right, the wheels of consolidation had already begun. If you look through 2019 and certainly a lot of the conversations that were happening and a lot of the deals were happening and that people were consolidating, improving efficiencies, improving assets and diversification. That was happening in the space and everyone realized that needed to happen, I think what this does, this period we're in with this sudden price drop, it accelerates that. It accelerates that thinking and those conversations on, you know, attracted widespread consolidation really across across the lower 48.
George Ward: 23:19
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George Ward: 0:00