How Far Will Bankruptcies Extend in US E&P Sector?

Copyright © 2021 Energy Intelligence Group

Oil and gas bankruptcies are reaching record levels in the US exploration and production sector and persistent low prices and scant hedges mean there is more pain to come. According to the Federal Reserve Bank of Dallas, nine oil and gas companies that accounted for more than $2 billion in debt filed for bankruptcy in the fourth quarter of 2015 -- the highest quarterly level since the Great Recession of 2008-09. In full-year 2015, 40 oil and gas companies filed for bankruptcy with total debt of roughly $16 billion. And while most have been minnows or lesser-known entities, larger companies have not been exempt from the trend, and lately some recognizable names have been stricken, including Magnum Hunter Resources and Swift Energy (related). More bankruptcies are a foregone conclusion, but the question is whether the leading credit ratings agencies have underestimated the number and scale of companies that could go to the wall. Standard & Poor's, Moody's and Fitch already have bleak outlooks for US E&Ps in 2016 (EIF Nov.25'15). S&P recently noted that the US distress ratio peaked for 2015 at 24.5% in December, with the oil and gas sector accounting for 127 of the 437 issues that make up the metric. The last time the distress ratio was this high was in August 2009 during the recession. With oil prices dropping below $40 per barrel and US gas prices still pitifully low at around $2.25 per million Btu, S&P has expressed concern about the lack of price-supportive hedges in place among producers: Among companies with speculative or "junk" credit ratings, only 29% of total output is hedged this year versus 46% in 2015 (related). S&P is most worried about companies rated "B" or lower and expects to see more defaults in 2016, especially after banks redetermine credit lines in the spring. Fitch notes that the December trailing 12-month energy sector high-yield bond default rate stood at 7.2% and forecast an 11% energy sector default rate for 2016. All three agencies spent much of their holiday season reviewing oil and gas companies for downgrades amid faltering prices. But is it possible they are still underplaying the risks? The ratings agencies famously failed to identify the risks associated with the mortgage crisis that precipitated the 2008-09 financial meltdown and their objectivity has sometimes been questioned due to their relationships with the companies they cover. Data from some independent financial analysts suggests that, without higher prices or consolidation, blood could spill up and down the E&P sector, putting some of its biggest names at risk. Rapid Ratings, which rates public and private companies globally using 73 financial ratios, is examining the US oil and gas sector closely, having foreseen the bankruptcy of nearly every oil company that filed in 2015 well in advance. Rapid's system applies a "financial health rating" (FHR) of 0 to 100 on a company, with those with a FHR below 40 considered at "high" to "very high" risk of defaulting on their debt over the next 12 months. The number of energy companies in this precarious category is now astounding. Rapid Chief Executive James Gellert tells EI Finance that a "little under a quarter" of the 800-plus public and private energy companies rated by Rapid now have FHRs below 40, with US E&Ps accounting for the bulk. In Rapid's system, 90% of companies that go bankrupt have a FHR of below 40. However, Gellert notes that a sub-40 score doesn't necessarily portend bankruptcy and that "some companies can weather the storm longer than others." He notes that credit deterioration in the US E&P sector has been taking place for years, as companies loaded up on high-yield debt to fund the shale oil boom. Last year delivered a "shock" in the form of low prices and today the outlook is "pretty grim" for E&P firms, which saw their FHRs on average fall by 17 points in 2015, compared to an average drop of 2.5 points for all other sectors. Companies with current FHRs in the "very high risk" category (a score of 0 to 19) include Approach Resources, Rex Energy and Goodrich Petroleum. Magnum Hunter had a FHR of 20 when it filed for bankruptcy, while Swift was also at the bottom of the "high risk" category (20 to 39) with a FHR of 24. Others toward the bottom of the high risk category include Halcon Resources (23), Resolute Energy (24), Penn Virginia (27), Gastar Exploration (30) and Triangle Petroleum (32). But more alarming is the appearance of larger E&Ps in the high risk category, including Anadarko (28), Chesapeake Energy (29), Whiting Petroleum (30), Newfield Exploration (33) Southwestern Energy (37), Bill Barrett (38) and Apache (39). Companies just above the 40 threshold include PDC Energy (41), Cabot Oil & Gas (42) and Devon Energy (43). Tapping capital markets remains an option for larger E&P firms, as recently demonstrated by Pioneer Natural Resources restructuring $1 billion in debt in public bond markets. But Pioneer benefited from a relatively strong hedge book and solid balance sheet, with an FHR of 68. With the sector now using all of its free cash flow to fund debt obligations, those with impending maturities could face difficulties that, for some, only bankruptcy may resolve. If the Fed continues to raise interest rates, as it is expected to, analysts note there will be fewer investors chasing yield, making it harder for companies with large, looming debt repayments to restructure. Moreover, volatile prices have made asset sales difficult because potential buyers aren't sure if prices have bottomed. Some companies will run out of options and bankruptcy will be their best way forward. Peter Kaufman, president and head of restructuring and distressed M&A at New York-based Gordian Group, says bankruptcy protection is the "gold standard for clean title" and that if a "seller's objective is to maximize recoveries then bankruptcy is their best bet." The process for a bankruptcy court-approved reorganization under Chapter 11 or liquidation under Chapter 7 is quicker and generates a "more robust process" compared to the alternatives for distressed companies, which include a general assignment for the benefit of creditors or receivership. While it's not guaranteed that a company will emerge from bankruptcy as a viable entity, it has a better shot if it files when it still has some liquidity and has at least part of a reorganization plan in place. Both Swift and Magnum Hunter -- each with more than $1 billion in debt -- have plans that involve a robust debt-to-equity conversion, where creditors and bondholders become the next shareholders. In contrast, Quicksilver Resources filed for Chapter 11 in March and still looks stuck today. It listed assets of $1.21 billion and liabilities of $1.35 billion and has been engaged in what's known as a Section 363 sale -- a public auction procedure -- of its North Texas and West Texas assets. In a 363 sale, which are common in most bankruptcy cases, a debtor or trustee executes a purchase agreement with a proposed buyer whose bid sets the minimum floor for an asset's price, known as the "stalking horse" bid. However, with bids due this month, Quicksilver has no stalking horse. Kaufman says the company was guilty of trying to "find a solution in bankruptcy rather than implementing one." M&A activity that has been stalled by volatile prices should speed up as bankruptcies mount. Distressed companies make for bad corporate takeover targets due to their high debt loads. Once these companies' assets are auctioned off in bankruptcy, however, potential buyers can acquire them piecemeal without incurring liabilities. But as Quicksilver's predicament shows, even assets without any associated debt may fail to attract interest in today's market. Valuation expectations may need to fall further, endangering creditors' chances for full repayment. While Kaufman expects majors and private equity to be buyers this year, they "may first need to see more pain and suffering" (EIF Oct.21'15).

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