A New Normal for Oil Companies?
By: Miles Pringle
On March 30, 2016 SandRidge Energy Inc. stated in its securities filing that it is considering a corporate reorganization through a Chapter 11 bankruptcy filing. Given the persistence of lower oil prices, SandRidge’s announcement was not surprising. The impetus for its announcement appears to be that some of SandRidge’s loans are coming due. The Journal Records’ Sarah Terry-Cobo reported that SandRidge must reach an agreement with the Royal Bank of Canada by the end of April or it will be in default. The purpose of the loan was to fund operational expenses, as opposed to capital expenditures, which is a troubling sign for a company that recently sold its most valuable real estate assets for a cash injection.
A Chapter 11 filing could help SandRidge reduce its considerable debt obligations with a plan that would “cram down” the amounts it owes its creditors. A filing by a company as large as SandRidge would be complex and expensive, but may turn out to be the company’s best option. Other oil companies have preceded SandRidge by filing Chapter 11 bankruptcy petitions, for example PostRock Energy Corp. on April 1, 2016.
We have already observed some of the effects of lower oil prices in Oklahoma County beyond the bankruptcy filings. Thousands of people have lost their jobs, many of which were good high paying jobs. The impact on the Oklahoma economy has yet to shake itself out. According to Federal Reserve unemployment numbers, Oklahoma’s unemployment rate in February 2016 rose .1% (to 4.2%) over February 2015, and payroll employment was down .4%. It should be noted that Oklahoma’s unemployment rate remains below that of the national average (4.9% in February) and Oklahoma County’s is even lower at 3.4%. Surprisingly, construction and home prices are up from the previous year.
Industry executives are predicting an uptick in both bankruptcies and mergers and acquisitions in 2016. See Federal Reserve Bank of Kansas City, “Tenth District Energy Survey”, released Jan. 8, 2016 (available at www.kansascityfed.org). In the Survey, respondents opined that “large debt loads would limit M&A activity and would instead lead more firms to defaults/bankruptcies.” One responder noted “Banks will want companies to sell assets and reduce debt levels as the year progresses. Still seems to be a considerable amount of private equity available, this money will be able to purchase assets cheaply in 2016.” Thus, a lot of dust has yet to settle in the oil industry.
Also contained in the Federal Reserve Survey was a prediction that oil prices will rise in 2016 (“$60 by year-end 2017”). Perhaps this projection is optimistic thinking, but there is some basis to believe that prices will rise. One reason is that the amount of new wells being drilled is falling. A data summary published by economist Chad Wilkerson (Vice President of the Federal Reserve Bank of Kansas City), “The Oklahoma Economic Databook: A summary of regional economic indicators for the state of Oklahoma”, noted that the number of active oils and gas drilling rigs in Oklahoma continued to fall sharply over the past year. Nevertheless, the overall crude oil production in Oklahoma actually rose during that timeframe.
The explanation relates to how new drilling techniques, such as horizontal drilling and hydraulic fracturing, work. The new wells may produce for up to 20 years; however, “they release about half their production over the first two or three years.” See Wilmoth, Adam, “Wells drilled in past 2 years provide nearly half of the U.S. oil; Oklahoma rig count down to 63”, The Oklahoman, published March 25, 2016. As companies lack the capital and incentives to drill new wells to replace current wells, the production in the United States and other countries should begin to fall.
How far supply will fall, and how quickly companies will fill that gap is the operative question in the industry. Collin Eaton of the Houston Chronicle reported that at the end of March, oil companies were sitting on a backlog of “drilled-but-uncompleted wells”. As the price of oil inches back up to break even points, cash strapped producers will bring these new wells on-line thereby once again increasing the supply of oil. Some experts believe this is not enough to cap any rally, but there are other factors which may hold oil prices back as well.
Some companies will not make it to their break even points. Luckier companies may be acquired by larger competitors (or cash rich investors); however, as noted by the survey commenter above, some of these companies have too many debt obligations to make their purchase attractive. Not all companies will be able to take advantage of a Chapter 11 reorganization, and some will be forced into Chapter 7 bankruptcies.
Barring a fundamental change in the oil market, it appears as though a new normal is setting in for oil prices. While the industry overall may benefit from lower production, individual companies are incentivized to increase production and many are in desperate need of the cash. We are a long way from $100+/barrel oil prices. The companies which emerge into this new normal will by necessity be much slimmer with different debt obligations.
Well placed, i.e. non-debt laden, companies will be able to purchase assets from distressed competitors and bankruptcy trustees for pennies on the dollar. These companies need not have vast amounts of cash on hand. Interest rates remain low, and the Federal Reserve has indicated that rates will not increase dramatically in the near to medium term. Companies can still take advantage of these rates. Banks will likely take hair cuts as the collateral that once secured larger loans from now distressed companies will be sold at lower values. The assets will then secure smaller loans for new companies. Smart bankers have been preparing for this inevitability and working with their regulators and borrowers to minimize impacts on the bottom line.
This Article was originally published in Oklahoma County Bar Association’s Briefcase Vol. 49 No. 4 in April 2016.