The value of an unfunded business plan.

To continue an unintended series about value, herewith some musings on cost of capital. About 6 months ago I wrote a post (“Financing “Oil 2.0″ will be more expensive. What is the WACC for your next Frac?”) commenting on how Shale 2.0 would be more expensive (and thus probably slower) than Shale 1.0

This theme of changing cost-of-capital – which should now be applied to the whole industry – results from a complex combination of factors. Most of the industry is suffering from a lack of interest in the sector, from public equity (both retail and money managers), as well as private equity. The latter, whilst well poised to take advantage of the downturn, is very selective, and becoming increasingly restricted by the views of their LPs and indeed the stakeholders of those LPs (typically students when the LP is a university endowment, or voters when it is a SWF). Big Oil is fast turning into Big Tobacco in the minds of consumers, albeit with a less obvious cost/benefit analysis. Climate Change, BigOil=Evil Empire, Pollution, and historically very poor returns on investments…. combine into a cliched “perfect storm”.

Whilst the equity story is tough, the real damage is being done in the debt sector. Many of the big name O&G lenders have gone (and here I am talking essentially about the non-US banking market, although the US has had similar trends), and those that remain don’t have anything like the appetite or balance sheet to step up to fill the gap. If we are, in addition, talking about Emerging Market lending; well it is very definitely “risk-off”, and there are rarely any local banks to turn to. Where local banks had started building a presence, irrational exuberance coupled with our wonderfully fickle oil price has resulted in them imploding on excessively overweight O&G loan books and now scary NPL numbers. Don’t hold your breath for a rapid return.

The only “bright spot” is that debt is still stupidly cheap (at least the base-rates). Whilst this is a macro economic theme well beyond the scope of this post (or of me), it does beg the question of how bad things will look if/when base rates start going up again… Maybe interest rate hedges should be on a CFO’s watch list.

So whilst thinking about this I have tried to plot the evolution of the O&G sector financing since I left the industry and went to the dark-side in 2001.

Texas wisdom

Back then, oil was at about $20/bbl, kind of in-line with its historical average and coming up out of the depths of 1998. The banking sector was dominated by Scottish banks (especially for the North Sea, naturally, but also occasionally more exotically) and the Best of the Rest were up and coming EM focused banks (BNPParibas, SCB etc). A rule of thumb that was handed down from the Texas-based Reserve Based Lending boys (Hi to Ralph and co!) was that about 70% of your loan value should be covered by PDP (proved developed producing – i.e. the existing production, lowest risk oil), and the remainder by PDNP/BP and possibly some PUD (i.e. those that needed limited Opex or Capex to access oil that was pretty certain to be accessible…). Any more technical risk than this needed more risk-adjusted returns via second-lien financing (high yield, mezzanine or any other name you chose). Anything that required development capex and risk (beyond PUD step-out wells) was equity risk. Cash Flow from operations was modest and reasonably predictable part of the capital structure.

NB: this sequence of graphs are a schematic view of the relative capital structure and WACC; values should be taken as indicative not absolute.

Walking on water

Fast forward to 2007 and the world had done a “dot-com” in the O&G sector. Banks were competing with each other (on price and risk taking) to get business – driven by the availability of huge amounts of cheap debt – thanks to the Sub-Prime doomsday machine. This was amplified by the commodities super-cycle that coincided, and drove oil prices up to the historical highs seen in 2008 of $147/bbl. It was uncomfortable as the old rules got buried in the frenzy for deals and PDP turned into PUD which morphed into 2P development risk in the more extreme cases. This was a good time to be an RBL engineer – any errors in judgement on the technical side were buried by the rising oil price. If it was a good time to be a bank engineer, it was a great time to be an oil company CEO or CFO. Walking on water was the norm as projects (acquisitions or developments) could attract up to 80% debt, the debt was cheap and a few months later, the rise in oil price made the pay-back calculation extremely flattering, even if it had been a stretch at the time of the deal. Many reputations (and retirement pockets) were made then. As the oil price climbed, so CF from operations grew, providing unexpected funding, and negating the need for any equity. Any equity raised at this point was done so on the back of a very bullish market and as such was of limited dilution (i.e. was cheap)

Out of the frying pan…

Oddly, the huge correction in 2008-9 had little impact, probably due to the rapid return to high oil prices, allowing most debt facilities and O&G projects the luxury of being able to wait out the dip. In addition, the financial melt-down caused by huge amounts of cheap debt was being fixed by, er…, huge amounts of cheap debt. This time it was not the banks but the Federal Reserves churning out the readies. The result was however mostly more of the same. For the O&G industry, lending banks started to pull in their horns chastened by the 2008-9 scare, and reduce the excessively risky lending seen in the peak of the oil bull market. The gap this left in the funding structure was immediately filled by high-yield (junk) bonds – driven by the huge appetite for yield, which itself was being created by the QE programs driving interest rates to historical lows.

One minor consolation was that (so far as I know) no one tried to slice and dice O&G bonds to make triple A rated CDOs out of them. 

The yields on some of these bonds were not much higher than RBL style loans, whilst being non-recourse. It was almost a badge of honour (to not use a less printable metaphor) for a rising star company CFO, to land a corporate bond – you had really made the big time. Courted by the usual coterie of (chose my adjectives carefully) bonus-drive Investment Bankers – this was good for the company and great for the ego. The dark side of this (but not the subject of this post) was that if/when these go bad – you don’t have anyone to talk to, until it is too late. RBL bankers, for their sins generally don’t want to own and run your oil company, so will seek to get their money back, without destroying you (the subject for a whole other post is just how you might enforce any of those loan docs in any EM situation, Texas it ain’t!). Bonds on the other hand are sold and resold, and by the time the problems are taken seriously, you’ll have a lot of very tough, very sophisticated and experienced distressed-debt guys (and an army of lawyers) across the table from you. 

Ignoring that digression, the capital structure was generally looking quite healthy with cheap ‘high yield’ bonds taking a lot of the slack from a modestly shrinking senior debt market, and CF from operations remaining healthy with oil prices consistently above $100/bbl, albeit this was being largely offset by rising costs.

Interestingly O&G share prices started falling many months before the oil price crashed in mid 2014.

Persona non grata

Fast forward again, to today. The senior debt market has shrunken massively with key banks all but disappearing, and actually disappearing in some cases. Only extremely conservatively managed, robust and large companies are able to attract new facilities. the rest fall into one of several buckets. “Give us our money back now”, “Pay us back as per the agreement but certainly don’t ask for any more”, or the latter plus “Ok have some more, as a bridge to getting repaid asap”. Emerging Markets are even less served than before. PDP lending is now back to being more or less the norm.

Due to a significant number of corporate defaults on bonds in the sector (and this is probably much more painful in the US than in Europe and EMs), the appetite for O&G risk has shrunk significantly. However for EM HY damage you only need to look at the recent history of independent O&G in Kurdistan to see the impact.

With oil at below $50/bbl Cash Flow from operations is contributing less to the capital structure (again partly offset by falling service costs).

In an ideal world Equity would be there to pick up the slack, but as noted at the top of this post, equity into the sector is having its own battles with image and returns. Share prices have crashed and as such any new equity is going to be very dilutive to historical shareholders.

The new reality is that there is a tranche of the business that is actually potentially unfunded in the current environment.  Of course nature and finance abhor a vacuum, so new financing products will develop as will new sources of traditional financing. The latter is probably a better bet, as generally, there are only so many ways to skin a cat, and ‘alternative financing solutions’ are either not actually alternate at all, or have some spikes.

Just a thought, but how long before we see the first crowd-funded O&G project ?

So the current funding options are probably more limited and hence expensive than at any time in the last 20 years. It would be very painful to be sitting on a large oil or gas resource that requires a huge chunk of capex to develop, and the debt markets are absent. If raising equity is the only solution, it will be horribly dilutive to the shareholders who funded the most risky part of the business (i.e. finding it in the first place).

If you can’t, or don’t, raise equity, well, you have an unfunded business plan, and the value of that, as we all know, is zero.

Epilog

Given the above, there is a conundrum for any CEO sitting on unfunded assets. If you recognise that the world has changed and you recognise that your cost of capital has gone through the roof, you will have to discount the value of your assets to get a deal with any more cash-rich counterpart. However to do so will almost certainly cost you your job when you take the bad news to your board and shareholders. Better to sit tight, keep taking the modest monthly stipend and pray for better days… or better to push for a dilutive deal, that will provide hope for the future: a very tough call indeed.