This article from the Wall Street Journal provides the background.
But the real question is “Why are investors continuing to fund the walking wounded?
- First, keep in mind that assets do not declare bankruptcy.
- Second, companies, do.
- Third, despite legal proceedings, assets will continue to produce.
Over supply will continue as long as revenue returned to those assets exceeds cash operating expense. Thus, one could argue bankruptcy is irrelevant to the oversupply of oil and gas. About all that has happened in oil and gas bankruptcy is the equity holders get wiped out. New investors arrive with fresh financing to buy the claims of the secured creditors and the dance goes on.
A feature of bankruptcy is Debtor-in-Possession (DIP). A DIP can obtain interim financing to keep operating while the court proceedings are resolved. DIP financing has priority over all other claims. If it is withheld, the dance stops and everyone scrambles to pick up the pieces. But it has flowed like water.
Who are the new investors and why do they play the game? The new investors are in most respects the same as the original investors. There are not that many institutions capable of making the kind of investment oil and gas requires. They include the insurance companies, retail investment companies, endowment funds, etc. Private equity has played an important role funding the shale revolution. Some got in early and have done quite well. Other funds that cater to high net worth individuals and institutions saw the train wreck coming and held back, waiting for fire sales. It is this latter group that is perhaps most differentiated from the rest. Having taken a bit more of a long view with perhaps some understanding of the fundamentals, the more patient investors have a different opportunity. But is it a better opportunity?
There are several reasons the dance continues.
- There is unprecedented liquidity (i.e. money) sloshing around in a very weak economy.
- As a result of all that liquidity, returns are so low that investors are willing to take on a lot more risk.
- There is a perception that the worst is over. Prices have risen to around $50/barrel and $3.50/MMBtu. Recent price movements have been more bullish than bearish. A cursory look at the situation could convince an investor that this is the time to move.
- Secured creditors are avoiding foreclosure on their assets. Banks really do not want to own and operate oil and gas assets. Asset sales are not preferred either. It is more expedient to provide DIP financing, keep the patient alive, and hope, pray or wish that things will improve.
- Most companies have slashed investment to preserve cash. They have learned to sustain production on their existing assets while minimizing operating expenses.
- That gray area between OPEX and CAPEX known as “the workover” has proven for some to be a pretty low cost way to squeeze incremental revenue from a steeply declining well.
- CAPEX money is going a lot further. Many techniques are being used to increase capacity at a lower cost. Longer laterals and more fracking stages are examples of how producers are wringing scale economies. It is a good story and investors are more than willing to fund it. But fundamentally it keeps production up, keeping pressure on prices.
- There is a large inventory of drilled wells, yet to be completed. A large fraction of the cost of a producing well is drilling. That cost is already sunk, so the incremental cost to complete is all that matters to the new investment decision. A company with DIP financing would be very smart to use this technique and new money certainly seems to be attracted to this opportunity.
At the end of the day, it matters little whether there are fewer companies. The market needs fewer barrels. Investors are looking for return. If that comes from a balanced market, that would be nice, but what they really need is for investments that provide a Return on Invested Capital (ROIC) that exceeds the cost of that capital. Maybe that will happen, but so far during this downturn it has been elusive.
In the meantime, we continue to see good money chasing bad money. I frankly expect to see that continue until a few fundamental changes occur.
- The Federal Reserve finally sees its way clear to start raising interest rates. A stronger fundamental economy would do wonders for that one.
- As a result, the Fed begins to soak up some of the excess liquidity by winding down its balance sheet, selling some of the government bonds it has amassed.
- Banks come to realize that funding zombie companies only forestalls the inevitable.
- Investors require producers to focus on ROIC and not production growth. That will take a new approach to the producer business model. Very few upstream companies have really taken that approach.
In future posts we’ll unravel the knot of what it takes to build a company with the People, Processes and Strategies to become an ROIC Champion.