Is this the beginning of another circa 2008 contagion effect?
Answer- Very possibly, YES.
Rest assured, the Cascade Effect has arrived.
Solving The 2016 Dilemma, Part Two: The Cascade Effect is Here
In Solving The 2016 Dilemma Part One, guideposts were suggested for fundamentally retooling companies seeking to migrate through the current crash in oil prices. Proposed was a fundamental underpinning equation: Experience plus Technology equals a positive outcome for E&P companies. In other words, a back-to-basicsapproach with a laser focus on tight operating costs in the field, using field personnel that brought historical knowledge on how production on conventional wells might be enhanced, and using proven new technologies to improve margins.
Now to try to frame and answer the question, “How big could the crash of 2016 be?” Joseph Triepke’s excellent article of 1/6/16 “Shale’s $200 Billion Debt Mountain” defined a staggering $200 billion+ of debt linked largely to unconventional reserves in the U.S. alone. That is a staggeringly large figure on its own, especially as it was only a handful of large independents that made up that figure. Reality check, this is very likely only the tip of a far larger iceberg. Inevitable realization of the entire Cascade Effect may well be profound shock and awe: the loss of intrinsic reserve values, evaporated quantities of reserves due to economic limits, highly constrained debt markets and an absence of equity markets, public and private. These could cumulatively prove to be quantitatively far greater than anticipated. In other words, the Cascade Effect, and possibly a broader contagion for 2016. (The article on The Cascade Effect was written for the Oil and Gas Investor in the third quarter of 2014, and published in February 2015.)
As noted in prior pieces, this crash is far different and far more fundamentally impactful than the 86/87 calamity. In 86/87, a major culprit was grossly bloated corporate overhead. My colleague William Weekley and I launched the Energy Vulture Funds in 1986 to grab those opportunities, and were fortunate to do so very effectively. Subsequently, tighter regulatory diligence on G&A scraped away the heretofore omnipresent: corporate jets, fishing and hunting camps, and in many cases, inflated C-level executive cash compensation.
Why is this price downturn fundamentally more impactful? Because this time the unmanageable culprit in depressed margins is at the field level. You can cut corporate G&A, but you can’t change what Mother Nature gives up if you are already employing state of the art completion technologies.
In every producing company there are four principal baskets of cash costs: corporate G&A; direct field level extraction costs; capital expenditures and financing costs. Wrapped around that are two fundamental economic axioms:
Level One: In a commodity based industry, when the price of the commodity goes below the extraction costs for a company’s revenues at the field level, plus the capital expenditures and its financing costs financing costs, that asset becomes impaired.
Level Two: If in that same company, on its’ existing assets, when the price it receives per unit (barrel/MCF) falls below the direct extraction cost (“LOE”), the asset is no longer impaired, it is worthless. A multiplicity of areas are there now.
At current prices, a very significant portion of E&P company assets have very rapidly deteriorated to Level Two.
The collective level of economic deterioration is what spawns a possible contagion effect for the economy as a whole. Consider these quants:
- Over $1 trillion of capital expenditures in North America alone since oil rose above $70 per barrel.
- Expected value creation from those expenditures at a minimum for collateral comfort is typically 3:1, thus $3 trillion of expected value from capital spent, in North America alone. The question is not how the profitability of those investments deteriorated. The questions are:
- How much of the $1 trillion will be written off as of yearend 2015? and,
- How much lower should the real value of the assets be marked down to, given that yearend prices under SEC Regulation SX are considerably higher than current prices, which may decline even further?
Here are some broad numerical considerations that drive this debacle, at the company level:
- Current field-level prices- At 1/9/16, WTI is quoted at $33. Per barrel. This by definition does not include deductions for gravity, sulfur and most importantly basis differential, e.g. transportation costs. WTI is quoted as delivered at Cushing Oklahoma. However, industry January 8 price bulletins quotes the same $33 WTI at Cushing as $29 per barrel in the Permian Basin. North Dakota sweet is quoted at $24.09. Sour crude in South Texas is $16.75.
- SEC averaged prices- SEC Regulation SX defines parameters to be used by public reporting energy companies in quantifying, pricing and valuing oil and gas reserves. Originally, the price the company was receiving at December 31 of the reporting year was held flat. The SEC subsequently amended its pricing policies to a basis of an average of the prior four quarters oil prices. The concept was to give a more realistic look at prices for a volatile commodity by averaging prices for the year. For yearend 2015, the average benchmark price for WTI will be $49, adjusted for quality and basis differentials. This compares with yearend prices of $93 in 2014 and $98 in 2013. The current market is a $33 WTI price. Lease Operating expenses on newer production are considerably higher than in the past (see #4 below). Thus a hypothetical $20 per barrel lifting cost yields a margin of $29 per barrel at the yearend 2015 SX denominated $49 price, versus the current state of $13 per barrel at the current WTI price of $33. That difference on its own results in a further margin compression of 55% in the current world, versus the SX defined world. Therefore, the SX calculation significantly inflates calculated Future Net Revenues, Net Present Values and in the process results in more physical reserves on the books due to changes in economic limit cutoffs. In short, the SX value is far higher than the current commodity priced value.
- All-in finding and development costs- Various industry surveys on most recent North American F&D costs are in a range of $23-25 per barrel. These costs may be low as they may not include Geologic and Geophysical costs expensed rather than capitalized and investments in leases not yet reclassified to exploration and development expense. Offsetting that understatement of costs, lower services costs will likely reduce those figures going forward perhaps by up to as much as 20-30%. These variables will differ from company to company.
- Lease Operating Expenses (LOEs)– LOE statistics are extremely hard to definitively quantify. The high end of the range is usually populated by unconventional reservoir horizontals (shales) that have already produced the majority of recoverable wells during the first 2-3 years owing to hyperbolic decline curves of 40-80% per annum initially. LOEs on this higher end of the scale, may range between $20-40 per barrel.
- Financing costs- Highly varied as presently imbedded in pre-defaulted credit agreements. The most recent financing of size was Energy XXI’s offering of $1.45 billion in March, 2015 at 11%. Highly unlikely that any transaction would be doable in today’s market.
- Corporate G&A- Again as with financing costs a very broad range, from $1-8 per BOE.
- Collateral value/Debt coverage- Owing to the inherent overvaluing of reserves under the pricing and costing methods used in yearend reserve reports that materially inflate margins, it will be extremely challenging for shareholders to gauge future solvency. Compounding that problem will be a need to understand cross collateralization and cross default provisions in all debt instruments. Likewise a detailed read of credit agreements to reveal conditions precedent to using “available bank lines” will be quite critical. Whatever figure you calculate from public documents for collateral comfort will be overstated. The question is only by how much. A figure that in yearend 10Ks will be exaggerated, meaningfully. Moreover, lenders continue to use escalated pricing that attempts to track the rising prices in a contango market.
Looking beyond the industry’s malaise, the ferocity and depth of the emergence of these problems may well influence macro-considerations. The convergence of these suggests a potential farther reaching contagion. Consider the following:
- Oil and gas companies’ bonds outstanding increased from $455 billion in 2006 to $1.4 trillion in 2014, a growth rate of 15% per annum. Energy companies have also borrowed heavily from banks. Syndicated loans to the oil and gas sector in 2014 amounted to an estimated $1.6 trillion, an annual increase of 13% from $600 billion in 2006.
- Capital expenditures since oil broke above $70 per barrel are estimated to be approximately $1 Trillion+ in North America alone. These projects would have been taken on with the expectation that a 3:1 uplift on capital deployed. Those expenditures were meant to create value of $3 trillion. The reality may be 20% or less of that number.
Based on the numeric factors enunciated above, the magnitude of this dilemma is seriously underestimated; especially when one considers the current WTI versus the published WTI in SEC disclosures; and the continued use by lenders of escalated price decks.
Now consider the impact using actual field level prices. Assuming NO quality and gravity adjustments of $24 (Bakken) to $29 (Permian Basin). Gravity and quality adjustments would have a decidedly negative impact on effective wellhead prices.
This begs the question of how a corporate entity creates a value accretive model from its own free cash flow which, as noted earlier, may be a price at the wellhead of between $24-29, assuming no further declines in prices (highly unlikely in the near term).
Finally, as lower prices will render a large number of wells uneconomic, plugging liabilities for those wells becomes an important hidden liability. While those obligations may be phased in over time, the liability remains and can readily breach senior debt covenants resulting in additional hard defaults. Qualified audit opinions on Going Concern, might well follow, and those are also generally considered a hard default.
Additive to the issues cited above, there are other elements that may further exacerbate the problem and eventually spur the birth of a credit contagion. These include, but are not limited to the following:
- The sheer magnitude of hard defaults will spur a climate of risk avoidance by lenders and bond issuers in general, possibly tightening credit access to other industries.
- Possible stress test mandates for lenders by Regulators. The loss of collateral value in 2016 resulting from an average price of $49 per barrel, may spur Regulators to require further stress tests based on current prices. Such tests would be highly debilitating.
- Further selloff in energy concerns bonds may result in broader impacts on non-energy borrowers as risk aversion grows.
- Cross-collateralizations of various debt instruments so that a hard default not cured within the curative period on any one instrument may well roll through to all debt and mezzanine transactions very quickly.
- Cross Default triggers between swap counterparties and lenders on individual companies may trigger significant payouts that OTC market makers and commercial lenders in swaps are stressed or even unable to pay.
- Syndications that may have placed now imperiled energy loans with banks not directly originating such loans and thus unfamiliar with the variables of the industry will emerge quickly. Those lenders may tighten risk tolerances for all industries.
- Absence of public equity markets to help cure over-levered companies will continue for some time to come, owing to the enormous losses suffered to date. It will accelerate in 2016.
- Substantial contraction of private equity markets with cash left in those funds focused primarily on helping existing portfolio companies and thus not available.
- Uncertain asset auction markets and thus realizations on liquidations well below the lender’s expectations.
- Inability of Lenders to process a quickly burgeoning number of hard default credits.
- Commodity derivatives counter-party credit risks on even swaps not in default will increase.
My colleague, William Weekley and I, looked at the basic culprits in the 2008 mortgage-induced credit crash. They were:
- Overinflated values
- Aggressive and lax lending
- Deteriorating credit worthiness
- Unregulated derivative market
- Underestimation of Lender exposure
- Expectations of price increases that would cover credit errors
- A three-year decline of 61% in housing prices on the Case Shiller index. (Oil has declined 69% in two years)
Sound familiar? That’s because it is. There is a very important difference—When housing prices declined 61% over three years, the house still had a $ value. By stark contrast, oil prices have declined 69% over two years and in a not small number of cases, there are now leases and wells on the books as collateral that because of high operating costs have no value.
Very significant on those leases and wells, they must not only be written off on the books, but will morph from an asset to an unexpected cash liability. Here is why. Nonproducing wells that hold a given lease must be plugged under specific procedures mandated by each State. A 6,000’ deep horizontal with a cased 9,000’ horizontal excursion leg will be a meaningful liability in compliant plugging. The State may allow time to do those, but the liability will nonetheless be posted on the company’s books. Plugging liabilities reduce collateral value and may help trigger another event of hard default. Under the chain of responsibility, company’s in the chain of title are liable first. In the event they are unable to pay those costs, the lenders are required to do so.
What, in general, is the sequence of events unfolding during the first half of 2016?
- The next several months will begin to reveal the depth of the problem in yearend 10Ks.
- Management conference calls with shareholders surrounding those filings will be replete with more bad news.
- Heated discussions with Lenders and bondholders will continue.
- Those with a fighting chance will have forbearance agreements as all the parties seek a solution.
- A significant population of smaller and midsize credits will be unsuccessful and seek avenues of liquidation and/or mergers.
- Hard working, loyal and talented employees will be laid off.
- Properties considered “non-strategic” will become available on exceedingly attractive terms for those who understand the elements enumerated in Part One.
Against that background:
- Producers globally will continue to produce all they can. Governments need revenues to assist in pacifying its citizens.
- Price Doves (Saudi Arabia and its allies) will continue to defend their right to market share.
- Demand may very well not live up to expectations, and
- Inventories will continue unprecedentedly high.
Price direction is obvious.
During this first half 2016 period, symptoms of a possible contagion may well begin to emerge and possibly spread rapidly. Many investors and lenders not deeply familiar with the industry are simply ignorant of many of the considerations raised herein. They will be educated very soon, and for many lenders and investors, it will be an event of shock and awe.
In Part One on January 6, I stated, “Was 2015 the ‘good old days’? 2016 might well make it feel that way.” This article outlines are the reasons why.
In the market of 2016, a properly structured Event-Driven Fund with skilled managers can profit handsomely. One note of caution: many of those seeking distressed opportunities with a paucity of deep knowledge on the interconnectivity of this industry may see this brave new world as a quick quantitative exercise that triggers where the right investments are and how much return can be made. Suffice to say, there may be yet a second round of opportunities that emerge as realities and as buyer’s remorse unfolds.
A most important personal closing note from the author:
In my 35 years in our industry, I have never found a topic so painful to discuss and write about. I take no pleasure whatsoever in noting these events to come. The industry has been very good to me and my family. Now we’ll see many hard working and dedicated friends of ours lose their jobs and their ability to make a livelihood for their families. In discussing the potential for this scenario over the past two years, I’ve noted that this is going to be far more impactful than 86/87, for these reasons. I take no pride in correctly having made that call. Far too many of my friends will suffer. I wish I had been wrong.
If we, as an industry, scrape off the shell of denial and fully grasp the interlocking relationships of this melt down and its impact areas, then we each have a fighting chance. If we pretend this is not the new world, we will be swallowed up: one job, one person and one company at a time. That is the reason I have taken a lot of time to put this together, so the readers at least know one person’s point of view and can stop, reflect and take from this piece what they like.
We are not at the discussion point yet on “too big to fail”. We are very much at the discussion point on “too big to ignore.” And, make no mistake, capital providers are already judging and culling out those it believes are “too small to succeed.”