Reality Hits Home For An Industry Carrying Too Much Debt

By David Yager, National Leader, Oilfield Services, MNP

“There’s just no cash.”

That’s the Coles Notes from a senior banker describing the book of oil service loans he manages for one of Alberta’s leading lenders. There’s simply not enough cash flow to support current levels of debt. Bankers and borrowers have kicked the can down the road about as far as they can as more oilfield service (OFS) and exploration and production (E&P) companies default on their loans and seek more relief on lending covenants. While a significant oil price increase to lift all the sinking boats will surely come, it won’t happen soon enough.

The foundation of global credit markets is based upon the borrower’s capability, obligation and commitment to pay the money back. The amount of money anybody can or should borrow is dependent upon free cash. The more free cash you generate, the more you can borrow. When free cash drops, the opposite is true.

So what happens when an entire industry can no longer service previous levels of debt?

ARC Financial produces a weekly chart calculating revenue, spending and upstream cash flow for the entire Canadian E&P sector. Selected data has been reproduced below. ARC calculates total revenue from all oil and gas produced, then deducts direct lifting and operating costs, taxes and royalties and the administrative cost of running the business. The result is “after-tax cash flow,” which is the free cash available for exploration, development, dividends and, of course, debt servicing.

Gross revenue from production sales is in blue and after-tax cashflow in red. The green line is 2015’s estimated cashflow compared to prior years. The figures are not corrected for inflation.

While the 2014 numbers aren’t finalized, ARC estimates total revenue was an all-time record $149.2 billion, generating after-tax cash flow of $67.1 billion, the second-highest in history. Combined with capital inflows from debt and equity and inter-company transfers, E&Ps invested $75 billion on conventional and oilsands capital expenditures (CAPEX, not shown). CAPEX in 2014 was also at an all-time record which created fabulous revenue and earnings for OFS.

This year is brutal. ARC expects revenue to plunge 33.6 per cent to $99 billion, the lowest number since 2009. Except for the recession, you have to go back to 2004 to find total revenue that low. But because today’s production mix is increasingly composed of high-cost oilsands, cash flow is expected to be only $28.9 billion, 43 per cent of 2014’s levels. This is the lowest level of after-tax cash flow generated by producers since 2001.ARC’s estimated CAPEX this year is only $39.1 billion, 52 per cent of last year’s levels. That’s why the active rig count is the lowest in years.

If the whole industry only has 43 per cent of 2014’s cash flow, then in theory it can only carry 43 per cent of last year’s debt. Of course, debt is not evenly distributed but the point is clear: the industry’s macro balance sheet is under stress.

At current oil prices, too many producers are not generating enough free cash for their debt levels. When you see reports some producers are cutting staff, slashing dividends and selling properties, that’s because they’ve hit the debt-to-free-cash wall. OFS is also in tough shape. E&Ps have demanded suppliers cut prices and vendors have complied. Free cash from operations is either nominal or non-existent. Some are in default, some are in special credit and some are insolvent. Service companies are also slashing or cancelling dividends. Like E&Ps, you pay your shareholders AFTER you have paid your banker.

Lenders are also in this mess up to their nostrils. They’ve been hoping this problem would just go away, a strategy with significant merit considering the alternative. The first quarter of 2015 was mostly shock and awe as prices tumbled. The second quarter looked promising as WTI recovered significantly. Borrowers requesting covenant waivers and forbearance letters were for the most part accommodated. No need to panic. Rising oil prices saved the day in 2009. Perhaps this would happen again.

But the summer of 2015 has been worse and sets the tone for the rest of the year. Oil started to slide in July, fell further in August until WTI reached a new six year low of US$38.22 on Aug. 24. Futures markets see no major improvement anytime soon.

What will lenders do? In the next few months, non-performing loans (offside of covenants) will be split into two categories: salvageable and hopeless. The former could live to fight another day. The latter may end up with new owners, new lenders or completely insolvent with assets auctioned to the highest bidder.

Salvageable loans will be those where management has demonstrated its understanding of the seriousness of breaching covenants and will have done everything possible to work with the bank, keep the credit in place and preserve shareholders’ equity. This includes cutting costs, slashing or eliminating dividends and raising equity or selling assets to reduce debt and de-leverage. Covenants will be amended and stretched. There will be a serious effort by lenders to keep these borrowers and loans solvent in the hope of future repayment.

Hopeless loans will be dealt with more expeditiously. These are companies with business models that no longer work or companies which are unable or unwilling to present the information lenders require to further amend credit terms that have already been amended. Impossible demands for cash will be made from asset sales or equity injections. When this can’t be done, the file will be moved to special credit. There, the lender will do whatever it must to recover as much cash as possible. Options include selling the debt or the assets at whatever price can be secured. Shareholders’ equity will be zero, current management will likely be replaced and companies may disappear.

There are significant pools of capital — equity and debt — waiting patiently to exploit opportunities. Valuations and calling the bottom have been major obstacles. Lenders will take care of that. Deals will get done.

To remain competitive if oil prices don’t rise significantly, the Canadian oilpatch must seriously de-lever. Everybody — lenders and borrowers  – will be taking a haircut until total debt is in line with free cash. Many companies will become “second owner businesses” as new lenders or owners restructure and reduce debt until it reaches a level the market can support.

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