The Impact and Opportunities of Falling Oil Prices

A year ago, on March 12, 2014, the Organization of the Petroleum Exporting Countries (OPEC) published its Monthly Oil Market Report announcing the price of oil was $108.55 per barrel for ICE Brent crude and $100.03 per barrel for Nymex West Texas Intermediate crude.  From the point of view of an oil producing state, the future price outlook was rosy.  Though there were recent modest supply increases, geopolitical events in Ukraine, Libya, and other locales were putting, and were expected to continue to put, pressure on supplies; and the market sentiment was “bullish on stronger 2014 oil demand forecasts and Chinese data showing oil imports reached record highs.”

Within a year, the price of oil collapsed, dropping essentially in half.  By the beginning of this month, Brent opened at $62.58 per barrel and WTI at $49.76.

As the OPEC report shows, this price collapse was sudden and unexpected.  Further, it followed a tremendous boom in the industry, when, for several years following the financial collapse of 2008 and the subsequent “Great Recession,” the oil and gas (O&G) industry was one of the few bright spots for the national and world economies.

In particular, during that period in the United States, strong oil prices and the domestic shale gas boom bolstered both the income and the balance sheet asset values of many oil and gas exploration and production (E&P) companies, while companies and investments in other sectors floundered.  This attracted increasing amounts of capital into the domestic E&P industry, and many E&P companies—both existing players and new entrants—accepted this cash by leveraging their balance sheets.  Whereas previously second lien debt was disfavored, recently E&P companies had taken on significant first and second lien debt to pursue E&P opportunities.  This leverage was dependent on the conditions that caused it—a stable and high oil price that provided companies both the income to service this debt and the balance sheet asset values to support the loans’ loan-to-value ratios.

The collapse in oil prices places companies that pursued this strategy in a difficult situation, to put it mildly.  Many of these companies now have neither the income nor the asset values to support their loans, a combination that risks pushing them into a downward financial spiral.  The decline in asset values, and consequent deterioration of loan-to-value ratios, will place many companies in default on their loans, requiring them to restructure their debt with additional loans at higher interest rates and with higher fees.  These loans will increase debt servicing costs and put additional strain on balance sheets, causing further declines in income and borrowing ability and constraining investment, leading to further P&L and balance sheet deterioration, requiring further financial restructuring.

Concretely, the price collapse accelerated in the fourth quarter of last year, meaning that, for publicly traded companies, the 10-K annual reports for last year will be the first public report of their new asset values and financial position.  The 10K reports for companies with stock values over $700 million were due at the beginning of this month.  The 10K reports for companies with a stock value of $75 million to $700 million are due at the middle of this month, and the 10K reports for companies with a stock value under $75 million are due at end of this month.

We unfortunately expect to see many companies this month announce their financial difficulties.  Many lenders will attempt to work with struggling companies, at least initially.  However, assuming prices do not recover in the meantime, the self-reinforcing downward spiral will make recovery difficult, and for some companies impossible.  Thus, by the third quarter of this year, and then increasingly by the fourth quarter of this year and first quarter of next year, we sadly expect banks’ patience and flexibility and many companies’ options to begin to run out.  These tribulations will lead to two opportunities.

First, companies that can both become lean and maximize their borrowing ability and spending flexibility—including with the skill and planning of experienced bankruptcy and restructuring counsel—will survive through a tough environment while many competitors are wiped out.  Later, when prices recover, these companies, and their management teams, will have the trust of markets and be in a less competitive industry, positioning them to profit.

Second, companies and individuals who did not increase their leverage in previous years, or who simply were not exposed to the oil and gas industry, will find investment opportunities as companies fighting for survival seek to raise capital by selling assets and to decrease costs by bringing in investors for key projects.  Three qualities will be key for investors wishing to take advantage of these opportunities: liquidity; the ability to move quickly when opportunities arise, including with an experienced and prepared legal team; and a strong network, including of financial and legal advisors who specialize in the oil and gas industry, to identify attractive companies and assets and to make discrete contact with sellers before companies’ issues become public and their assets are offered to the public.

The price collapse is indisputably horrible for the O&G industry, and a challenge for everyone in it.  However, tribulations beget opportunities for those who survive and are properly prepared.

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