The pandemic of 2020 was undeniably a choke point for investment into the oil and gas industry. Reduced travel, and a general hesitation to invest in anything other than masks and toilet paper, coincided with a rise in ESG concerns to block the door to any significant investment in the sector.
But, said Jack Herndon, Frost Bank’s senior vice president of Energy Finance, the months leading up to the pandemic were already rife with warning signs.
Rising prices for acquiring acreage, drilling, and other operating costs had already given pause to Wall Street investors over those months. “People were questioning how they were ever going to achieve the rates of return they were promising. The IPO market chilled, then the bond market started to slow down tremendously. Then we saw private equity firms, in tandem almost, start to pare back their activity.
“So there was already a move to operate within cash flow and start to return capital to investors prior to COVID. I think all COVID did was speed that process up almost overnight.”
Herndon feels the markets often overreact to external stimuli because “there are so many external forces profiting on the swings. There are a whole lot of traders out there that are putting calls options on oil if it goes up and put options on oil if it goes down—speculation.” It seems that only the producers make money from price stability.
For producers, the pandemic forced a return to capital discipline. Over the preceding 5-10 years, private equity (PE) firms were almost writing blank checks for both producers and service companies, asking them to use the money for growth so that the investors could make their money at the end of 5-7 years by selling at a profit—not interested in showing a short-term profit.
But that model was already showing cracks by 2019. So, “What 2020 did was to force a return to capital discipline,” Herndon said. “E&P firms have been forced to rely on conservative use of their bank debt and cash flow to fund their drilling programs.”
One way the market is different today as opposed to recent years is in hedging requirements. “The financial covenants are tighter—banks have instituted hedging requirements for most deals. You want to see your borrowers are hedged out at least eight months to two years.”
This manages commodity risk by setting a floor price for selling oil.
ESG issues are also hitting oil and gas financing. Herndon gave some background on how that’s changing the landscape.
In recent years one funding option was to assemble a limited partnership (LP) that would approach institutions such as pension funds, endowment funds, and others for capital. Until recently, he said, companies could use that money to buy properties and either boost production or use another method to provide financial gain to the LP.
“What we’ve seen,” said Herndon, “and this was the canary in the mine—when those folks (LPs) went back out into the market to try to raise money from some of their limited partners they had been able to count on for numerous iterations previously, basically they didn’t want anything to do with the upstream oil and gas industry.” Many of those refusals came from California-based family offices or foundations, or major university foundations, who were acting on perceived ESG principles.
Frost Bank—based in San Antonio and with all its branches in Texas—is feeling the ESG heat itself. The bank now has an ESG questionnaire that oil and gas borrowers must fill out, to show depositors that the bank is ESG-aware, Herndon related.
“Some of the CEOs of the local companies have been pretty outspoken” about the need for ESG awareness. “They live here, they have families here. It’s not like they want to pollute the environment.”
Deals that are happening in these times are unlike what was happening before the pandemic. “A theme over the last couple of years has been consolidation. I think that consolidation means that the surviving companies have to high-grade their projects,” he said.
“We’ve seen a number of different parties that are actually just going out and buying PDP (proved, developed, producing) assets. They’re buying existing production. Their business model is to buy that existing production. They’re not baking in any kind of projections based on their ability to drill new wells and increase cash flow.
“It’s more like, ‘Let’s buy this, let’s operate it efficiently, let’s strategically complete workovers and do other things to enhance production.’” They want to be efficient and, “From day one, start amortizing. We’re structuring amortizing loans.”
Amortization is used to create tax deductions for a depreciating asset. The days of dreaming of 5-1 asset growth in the shale boom have been replaced by realities connected to steady production and asset management bringing nearer to 20 percent profits.
While Herndon noted that these deals are far from the norm, the fact that there are any at all is a new development compared to recent years. PDP deals are more available now due to two main reasons. One is that the previous owners need cash to service debt. The other is that, after a large consolidation, the new company is shedding underperforming assets.
Looking to the foreseeable future—recognizing that foreseeing is harder now than it used to be—he said, “In the near term, we feel like net next 12 months is going to be a period of stabilization in the markets, and continued capital discipline on behalf of the E&P firms in the marketplace.”
Most oil and gas experts, he noted, do not expect Permian production to grow significantly, alluding to a “flattening of the curve.”
Tyler Hoge
Tyler Hoge, Senior Associate with Enverus, noted that, “In 2018, that’s the last time times were good before COVID.”
Over the preceding 10-year period oil companies saw a lot of capital destruction in the marketplace as the rapid production growth was failing to produce the expected revenue when oil prices fell to $50 per barrel. In the days that oil traded north of $100 per barrel, there was a kind of euphoria that pushed some bad decisions.
“Everyone thought these high oil prices would last forever, so all those dollars spent in the higher oil-priced environment were going to waste.” After the market’s precipitous drop, there was an illusion that the market would recover, so much of the frantic drilling still continued. Producers were taking on as much debt as possible with the hope it could be paid back when the market recovered.
When it didn’t, even before COVID, “Investors were leaving the space; there were a ton of companies on the brink of bankruptcy. They were drilling wells whose break-even levels were higher than then-current prices. Investors felt cheated for the longest time.”
After a decade in which “the mantra was production growth,” over the last couple of years it’s switched to free cash flow, and that’s what helped the industry be more capital disciplined.
With this new capital discipline, Hoge said, operators are happy with $55 per barrel oil, and are looking for wells in a “sweet spot” of making money at $40 or less.
So where are producers finding capital now? “The debt markets are open, there are a lot of bonds that are being oversubscribed. Equity, however, is hard to come by. Nobody’s having IPOs” because of the lack of equity investment.
With the drop in prices and demand, E&Ps are more cautious with capital expenditures even as oil prices have sniffed $70 or more. “Everyone’s a bit more cautious in terms of capital being spent. Everyone’s loving the free cash flow and returning cash to shareholders,” Hoge said. The added Sword of Damocles is the fear that oil prices could tank again quickly, possibly eliminating that cash flow overnight.
This doesn’t mean a complete lack of production growth. Hoge sees privately held companies leading the way in that area because they’re not beholden to shareholders. “At the end of [2020], privates made up about 30 or 35 percent of the total rig count. Now that count is up over 50 percent.”
Some of the majors are still budgeting for production increases as well, he said.
He pointed out that Diamondback recently announced a capex increase of 10-15 percent for 2022, for the purpose of just keeping production flat. “So they’re committed to that maintenance program, and I think a lot of other publics will follow suit.”
Slow but steady should play well with financial markets. “The financial markets are disciplining operators that are growing.” Companies forecasting even small amounts of growth get pushback from markets in the form of stock price drops following such announcements.
“I think as we go into 2022 we’ll continue to see maintenance programs or max growth of single digits.” Main sources of money for that will likely be from either private equity or bank loans, he said. With low interest rates, debt is comparatively cheap in the current environment, he observed.
In a way, both Herndon and Hoge see the pandemic as a wakeup call for the industry, forcing it to face the reality that continued expansion based on loans or investor money—instead of cash flow—is unsustainable.
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Paul Wiseman is a freelance writer in the oil and gas sector. His email address is fittoprint414@gmail.com.