Market Comment: High Cost of Debt Service Weighs on Struggling US E&Ps

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Crude oil prices have rebounded off their early-2015 lows and oil-field service costs have eased, but the pressure remains acute for many US-based E&Ps. Many have taken on large debt loads to finance high-cost unconventional development, and servicing this debt is proving more difficult with oil prices in the $50-$60 per barrel range than it was 10 months ago at $100/bbl. The pain is most acute for companies with speculative-grade liquidity (SGL). Moody's said energy companies accounted for eight of the 21 US corporate defaults among SGL-rated companies so far this year, and expects the situation to deteriorate further, with the overall default rate for SGL-rated energy companies seen rising from 1.9% in May to 3.1% a year from now. The strain of persistently low oil prices is evident in the proportion of revenues eaten up by interest expenses in the first quarter. A survey of five hard-hit US E&Ps by EI Finance found that interest payments ate up on average 39% of the group's total revenues during the period, compared to 18% in the year-earlier period (see table). Many of these operators have opted for a painful recapitalization as a near-term solution. Swift Energy announced late last month the launch of a five-year $640 million senior secured loan with proceeds earmarked for paying down $263 million in outstanding borrowings and general corporate purposes. The news prompted Standard & Poor's to revise its outlook for Swift's "B-" corporate credit rating from stable to negative. S&P analyst John Rogers said the downgrade reflects the possibility that "leverage could deteriorate beyond our current expectations, remaining at levels we would view as unsustainable in 2016." Interest expenses consumed 27% of Swift's first-quarter revenue, and the company reported an adjusted net loss of $36.5 million. A handful of companies have entered selective default, exchanging a portion of their long-term debt for new common stock or secured notes that have a lower value. This list includes SandRidge Energy, Halcon Resources, Midstates Petroleum and Warren Resources (EIF Jun.3'15). However, new debt like this comes at a high price. Credit ratings agency Fitch says the average interest rate for new, high-yield "junk bonds" rose to 7.3% during the first quarter, up from 6.2% a year earlier. American Energy-Woodford, a private equity-backed venture led by former Chesapeake Energy Chief Executive Aubrey McClendon, discovered this with its recent exchange of $350 million in senior unsecured notes for second-lien notes worth $237.6 million (EIF Jun.17'15). The new debt carries an interest rate that is 3 percentage points higher than its old notes, at 12%, and the exchange added American Energy-Woodford to the list of firms that have entered select default. Vulnerable producers are pursuing various financing options that include joint ventures, divestments or outright corporate sales. Struggling Rosetta Resources was scooped up last month by better-capitalized player Noble Energy in a deal valued at $3.8 billion, but so far mergers like this have been the exception (EIF May13'15). Struggling Utica Shale operator Magnum Hunter just announced it aims to raise $600 million-$700 million from the sale of its remaining 45.5% equity stake in an Appalachia gas gathering system (EIF Jul.1'15). It is also pursuing joint ventures for its Utica Shale assets in Ohio and West Virginia, which are expected to generate another $400 million-$600 million. Magnum Hunter saw 42% of its first-quarter revenue of $55.4 million consumed by interest payments. It has set a capital budget of just $100 million for 2015 and does not plan to drill or complete any new wells after the first quarter. Chief Executive Gary Evans sounded confident at Hart Energy's recent DUG East conference in Pittsburgh that the midstream sale and joint venture deals would be made, allowing the firm to shore up its balance sheet and begin to bring back drilling rigs in the second half of the year. E&P companies also have turned heavily to the equity markets to secure additional capital. Wells Fargo has estimated that since the beginning of this year, more than $11.5 billion in equity has been sold by US oil and gas producers. Analyst David Tameron recently said he's expecting more equity offerings in the second half of this year. "We would hope the market will be more discerning in [the second half] than it was in [the first half], and we are starting to see evidence that may be the case, but we aren't holding our breath," he said. Tuscaloosa Marine Shale-focused operator Goodrich Petroleum, for example, raised $148 million from the sale of new shares and three-year notes during the first three months of the year, and it recently resumed planned completion work on six uncompleted wells in the play. Interest expenses totaling $12.1 million burned through 50% of Goodrich's first-quarter revenue and the company's capital budget is set 50% below 2014 levels, with a guidance midpoint of $100 million. Goodrich expects to raise more funds in coming months through a joint venture of holdings in the South Texas Eagle Ford Shale (OD Jun.23'15). But cash-flow deficits are proving too large to plug for other distressed E&Ps, and a growing number are resorting to bankruptcy, with even more teetering on the brink. Within the ranks of those firms filing for bankruptcy protection are BPZ Petroleum, WBH Energy, American Eagle Energy, Quicksilver Resources and Saratoga Resources. More producers could follow as protective hedges roll off later this year and into 2016. Tameron said that E&P companies were reluctant to lock up low hedge prices for 2016 and are "continuing to express the optimism that is a hallmark for the industry." KeyBanc data on 32 shale producers shows that 62% of 2015 oil production is hedged at an average price of $77.34/bbl. However, just 32% of 2016 output is hedged -- and at an even lower average price of $72.58/bbl. With lower realized prices further pinching revenues, bankruptcy filings and industry consolidation could accelerate. Interest Payments Eat Up E&P Revenues in Q1 Interest Expense Total Revenue Interest Expense Company ($ million) ($ million) (as % of Revenue) Goodrich Petroleum $12.1 $24.0 50% Swift Energy 18.2 68.3 27 Halcon Resources 61.3 136.2 45 Magnum Hunter 23.4 55.4 42 Penn Virginia 22.0 74.5 30 SandRidge 62.9 215.3 29 Rosetta Resources $22.0 $173.1 13 Group Average -- -- 39% Source: Company filings

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