As crude oil futures bounce around, the stability for the smaller exploration and production (E&P) companies certainly hasn't come from the stock market. Many companies were fortunate enough to get their equity financings done by Labor Day.
The flurry of high-yield deals done in the spring and summer has been widely noted. One might also note the recent underperformance of these bonds and shares issued in equity follow-ons. It has been hard to miss.
Unconventional drilling still requires upfront capital, and when the markets convulsed, that was the biggest risk. The real danger was not a prolonged slump that would make well-drilling programs "uneconomic." The real danger was that companies would simply run out of capital to complete existing drilling programs.
To those who accuse companies for spending more cash than they generate: have you been paying any attention to the energy sector over the past four years?
"Outspending" is common. It simply involves an intimate understanding of the internal rates of return (IRR) on a series of projects. Current capital expenditures should exceed current cash flows, if the IRRs on those projects exceed a risk-adjusted hurdle rate. A good CFO would probably add a point or two to the hurdle rate for the sake of cushion.
The markets (equity, high-yield, or the mezzanine preferred stock market that I favor for my clients) simply stopped doing this analysis on drilling companies. Is it easier to to re-do your model, adding in an $81 oil price, or just sell indiscriminately? A glance at the charts of smaller E&P stocks over the last month shows that "shoot-first" won over "re-analyze."
Nevertheless, one group is still doing basic blocking and tackling to analyze the creditworthiness of E&P companies: the banks.
Yes, good old commercial banks. FDIC-regulated depository institutions. They are boring, compared to the hedge fund high-fliers who had been riding the "shale boom" as recently as six weeks ago. Yet, these banks are so much better-informed, and they are still lending.
A typical E&P credit arrangement produces a periodically-reviewed borrowing base determined by reserves. The bank will use a "deck" to determine the level at which those reserves (which become future production) are valued and then discounted. The days of the "hundred-dollar deck" may be behind us, but that has not curtailed activity at all.
Bankers and CFOs are merely repricing credit facilities to reflect lower oil prices. Crucially, they are still doing business.
A plethora of announcements from the past three weeks trumpeting expanded borrowing bases will fill your screen with household names in the E&P sector: Anterro Resources (AR), Carrizo Oil & Gas (CRZO), Penn Virginia (PVA), SandRidge Energy (SD), PDC Energy (PDCE), and so on. The list is quite long, and I chose that search because the term "borrowing base" is used so specifically in the energy sector. Slightly different wording in the search would unearth the $390 million in new credit facilities raised by Portfolio Guru core holding Magnum Hunter Resources (MHR), among many others.
Both new and newly-expanded sources of capital are available and being used. That money is going straight into the ground to produce more hydrocarbons. Ultimately, it is volume (especially given aggressive hedging programs which are required by most banks' E&P lending departments) that will determine creditworthiness.
When we sit down in January and look back on the October swoon in E&P preferreds as a huge buying opportunity (an energy preferred portfolio of mine has risen 12% in two weeks), we have to thank the confidence of the banks.
