Caught in a trap: most US E&Ps are burdened in debt, unable to generate free cash and replace decline, even at “normal” oil prices
Frontispiece: Soulless, empty, and purposeless, starved of fresh investment because of lack of free cash and profitability at anything less than $50/bo oil price, burdened by debt and devaluing assets, many US E&Ps are the Walking Dead. Image source: Skybound.
A couple of months ago I wrote a piece on my website about the five brutal facts that the US oil industry and energy makers must confront while planning for the post-coronavirus world. One of the most brutal facts was that the sector had struggled to make money over the last decade and at oil prices less than $50/bo offered little prospect of doing so in the future. I offered some options to move forward in a progressive way within the energy transition, a ”build back better” plan if you like, starting with a radical re-basing and cost optimization of the US upstream industry. I expected some companies, particularly those with the less attractive assets, to cut their losses and merge with equals, some to try to grind it out through cost-cutting and refinancing with the hope of higher prices in the rebound, and the rest to seek safe haven in Chapter 11 restructuring.
Figure 1: Bankruptcy trends in the US oil patch. (Source: Data: Haynes & Boone, LLP; Graphic: Capriole Energy).
However, according to Haynes and Boone, LLP who monitor bankruptcy in the oil patch, there isn’t a herd of oil bankruptcies happening, at least not yet compared to prior years, including 2019 (Figure 1). There have been several higher-profile filings, Ultra, Unit, and the perhaps most significant, Whiting, once a dominant player in the shale “phenomenon” in the Bakken play. Chesapeake are now reported to be within a couple of weeks of filing for bankruptcy protection. The majority of 2020 filings in the Haynes & Boone list are private LLCs, the largest in terms of debt is $618m associated with Sheridan Holdings I, LLC, part of private equity-backed venture with assets in East Texas. In total $10 billion of debt has gone to the wall of bankruptcy so far in 2020, which although very big money to most people, is a small fraction of the debt burden carried by the industry (Figure 2). In this piece, I restate the case for change as a deeper analysis of the cost of supply creaming curve for nearly 10 million boed net production from 36 US E&PS. Most companies appear to be currently trapped in a “death spiral” of value destruction and debt accumulation. I offer some benchmarking data that both illustrate the variety of cost structures in E&P companies and show what might be possible to transform the fortunes of some companies, at least those with access to the best quality assets. It appears to me that the best solution for the other zombie companies is some form of bank-led amalgamation of bankrupt or stressed assets to optimize the depletion and cash return.
Figure 2: Debt burden of 36 E&P companies assessed in this study. (Source: SEC FIlings and Capriole Energy).
Financial performance of the sector was already abject, before the March 2020 price crash
Figure 3 presents the net production of 36 E&Ps as a creaming curve to pre-tax profit and EBITDA in 2019. The plots show that roughly half of the 10 million boed production was delivered with no profit in 2019. Even when the big loss margins are adjusted for impairments and write-downs, the picture is not significantly better. In 2020 the oil price has been on average $20/boe less than the 2019 average and hence all of these companies might be expected to be loss-making in 2020. Earnings Before Interest Tax Depreciation and Amortization (EBITDA) shows the earnings potential of a BOE in 2019 and that with the same $20 drop in oil price the earnings margin is eliminated for about half of the production from the 36 companies.
Figure 3: Cumulative 2019 production (MMboed) of US E&Ps against Profit before tax and EBITDA. (Source: Data: SEC Filings; Graphic: Capriole Energy).
Same basic problem with ROCE
Another traditional financial measure of a company’s performance is Return on Capital Employed (ROCE) on which several US E&Ps have refocused in the last couple of years. Notably the ones that talk about ROCE are the same firms that have been recently delivering high single-digit or even better into double digits! Figure 4 illustrates the spread in ROCE values, together with the obvious relationship to Profit before Interest and Tax (PBIT) on which ROCE is calculated in this analysis with capital employed being total assets on the balance sheet, minus current liabilities. The same basic underlying problem undermines the sector’s performance on ROCE: oil prices lower than $55/bo whack the returns.
Figure 4: PBIT per BOE versus ROCE for the 36 companies in 2019. The right hand panel details to subset boxed in the left hand panel. Bubble size is scaled to annual production. (Source: Data: SEC Filing; Graphic: Capriole Energy).
The best of a bad bunch and an “ideal” E&P company
The leaders in Figures 3 and 4 are also interesting to note. While no company has profit resilience to a $20 price drop, ConocoPhillips (COP), Denbury (DBR), EOG, Continental (CLR) and Pioneer (PXD) are the top five companies in terms of profit margin. All but one of these have relatively higher revenue per BOE numbers because of additional revenue streams from marketing (Figure 5). CLR has a very good cost structure and therefore makes profit on a lower revenue per BOE.
Figure 5: Pre-Tax profit/loss structure per BOE in 2019. (Source: SEC Filings, Capriole Energy)
The top five for earnings performance and hence resilience to price drop are a little different, Hess (HES), COP, Kosmos (KOS), Sundance (SNDE) and Diamondback (FANG). With the except of COP, these top five earnings generators failed to deliver income because of proportionately higher non-cash costs, specifically DD&A, which is I take as a measure of the long term efficiency of the capital invested in the business. Capital productivity is discussed further below.
Figure 6: Cost categories versus percentage of total production in 2019.
The ideal Company
This inquiry on cost performance and margin can be further deepened by asking the question of what would an “Ideal” company look like, one that performed top quartile or better still top decile in each of the key parameters and hence related activities?
The “Ideal” company would maximize revenue by positioning in the most favorable markets and optimizing derivatives for oil and gas, and applying the capability of the business to capture additional revenue streams such as marketing, or in the case of DBR, sales of CO2 or CO2 tax credits. A bias to oil than gas is of course important as shown by Devon (DVN) who are in the top quartile for all cost categories in Figure 6, but have much poorer bottom-line performance (Figure 3).
The ideal company would invest in technology and best practice to drive down unit cost in operations. Ten companies delivered top quartile lifting cost per BOE performance in 2019, at less than $10/BOE. Interestingly, not all the companies in the top 10 are big, so small firms can be lean and economy of scale may not be necessary.
Our Ideal company would manage overhead through agile working, digital transformation, and apply resources to the right things. For G&A costs per BOE, there appears to be a size hurdle for a company to be of a certain scale to be able to deliver top quartile of $1.50/BOE or better.
Perhaps most important of all to our ideal company, our ideal company must be able to replace declining base production with new well production to at least sustain a plateau at capital costs that doe not exceed operating cash flow. This requires drilling good wells at low cost.
Attributes 1 to 4 must be done by the Ideal company with cash flow from operations, as well as having sufficent cash remaining to pay interest payments and other cash costs and have a significant proportion of cash left to distribute to shareholders. Non-ideal companies, outspending their ops cash with capex, have the only recourse is to get the cash from financing activities, typically more debt. This pattern of behavior has dominated the US E&P sector, and, as discussed further below, had led to the zombification of many firms, even those with reasonably good operational performance.
Our ideal company needs a capital structure and balance sheet that is resilient to price volatility and is geared to the sweet spot of the leveraging the business with affordable debt. Healthy gearing ([debt]/[debt + equity]) is much less than 50%, more like 10 to 30%. Most US E&PS had already high gearing ratios in 2019, so they are more vulnerable to balance sheet stress in 2020 (Figure 8). Similarly using interest cover (=[profit before interest and tax]/[interest]) as a measure of a company’s ability to meet its interest obligations, it can be observed that there are quite a lot of firms with interest cover ratios less than the desired value of 2, and a few in negative territory because of net losses in 2019.
Figure 7: Weighted average, top quartile and top decile per BOE costs in the analysed group of companies. (Source: SEC Filings and Capriole Energy).
Figure 8: Gearing and Interest Cover for the 36 E&Ps in 2019. (Source: SEC Filings and Capriole Energy)
Borrow, drill, decline, repeat
But is an ideal E&P company exploiting North American resources even possible? At the high price regime of 2010-14 a profitable shale industry certainly seemed possible, and that environment catalyzed the shale revolution. Even the price downturn of 2015-16 did not really alter the investment thesis of reserves growth (together with production and EBITDA growth) improving the valuation (and hence stock price). However, in 2018 investors began noticing that most of the sector had a pattern of investing more cash that they earned from operations, reflecting the brutal reality that a lot of American oil is expensive to develop and produce, and full-cycle does not make money at less than $55/bo. Some companies, like EOG and COP, reined back and commenced a disciplined approach to capital deployment and living within operations cash flow. But even those companies, growing the habits of our Ideal company described above, remained vulnerable to sub-$55 prices. Many other companies continued the sustain or grow mode, outspending ops cash by issuing more equity and or borrowing more debt (Figure 9).
Figure 9: Capex/Cash from Operations virus 2018-2019 production growth (Source: SEC Filings and Capriole Energy)
Figure 10 illustrates the history of 6 companies outspending operations cash, with EOG being the “best” of the 6 illustrated, and the other five representing most of the rest of the sector. In addition to the misleading investment thesis that shareholder return related to reserves growth, I think that many companies have been caught in a “death spiral” trap because of debt covenants based on minimum hurdles of EBITDA/Debt. Unconventional shale resource wells decline rapidly, and a review of a sub-set of the 36 firms in this study indicates that base production, developed in prior years, declined about 30% during 2019. Thus companies must keep drilling to replace that 30% gap, let along grow. The companies illustrated in Figure 10 all , with the partial exception of EOG, have been serially outspending operations cash with investment capex, and have been issuing new equity and borrowing more debt to replace declining production and further grow. The problem has been growing in “death spiral” as each year’s newly invested capital is no better than the previous year’s in terms of cash productivity, so the gap between ops cash and investing cash required to sustain
Figure 10: Six examples of value destruction in US E&Ps, each company outspending (through borrowing) its operating cash flow to drill more wells to maintain or grow production (and EBITDA) (Source; Yahoo Finance and Capriole Energy)
Figure 11: The US E&P industry was in a “death spiral” already, the oil price crash in March 2020 was simply the Wile E Coyote moment when a narrow precipice turned into thin air.
Options for the future
Prolonged low prices are of course stressing the balance sheets of all oil companies. A good number have already filed for bankruptcy and others have warned of debt concerns because of potential failure to meet covenants or lack of ability to pay interest. However, with equity becoming irrelevant, it’s the banks that have the first call on the companies remaining value, and they are likely to want to avoid a complete write off of the debt. The problem is of course that without oil prices much higher than $55/bo, it is clear that creating a virtuous cycle of sustained production, improving returns and cash dividends is very unlikely to be delivered by the zombie firms that have previously been stuck in the death spiral.
The cost structures of the Ideal company are compared with a “Zombie company” in a simple conceptual model of a 50,000 boed firm replacing its production annually in Table 1. I first compare the two companies at $50/bo price. The zombie gets less revenue per boe, and its cost structure, the weighted average of the 36 companies in this analysis, and its lower capital efficiency do not deliver enough ops cash to provide for new capex to replace production, let alone other cash demands. Hence it has to borrow to sustain. The Ideal company, with a cost structure that would be top quartile in 2019, and a 20% better capital efficiency than the zombie, is able to sustain and provide free cash flow.
I then compare the breakeven revenue per boe values for the two (Table 1). The Zombie, with its inferior cost structure and capital efficiency, needs $48/boe revenue to cash breakeven, implying an oil price of more than $55/bo given the Zombie’s inability to realize price. In contrast, the Ideal firm needs $31/boe revenue.
Is it possible for the existing companies in the sector to become Ideal? For some that can avoid bankruptcy or similar in the current run of very low prices, my answer is “perhaps”. The shifting strategies of COP and EOG to cash and capital discipline are attributes of the Ideal company. COP and EOG suggest that size is likely to be important if not critical in providing economies of scale and quality through choice of investment targets such as the best well locations in the portfolio (EOG’s “premium well” strategy). I am still not sure that there as sufficient high-quality assets to go around, and I expect that the realities of resource quality will mean reduced US production even if the zombies are eliminated or assimilated into bigger, higher-performing companies. The recent Dallas Fed survey suggests that there are quality well locations able to breakeven (presumably on forward wellhead economics) at $40/bo or less, largely in the Permian basin and in other US conventional resources (Figure 12).
Table 1: Conceptual model of an E&P company replacing 100% of its base decline in a variety of scenarios.
Figure 12: Breakeven oil prices for new wells (Source: Dallas Fed Energy Survey).
I also continue to worry about the commitment and competency of executive teams and the Boards to effect the profound systemic and cultural shifts necessary. For example, there has been a worrying number of examples of execs looking after themselves, more than their shareholders, with a lack of prudence and well-judged challenge from their Boards.
For the non-ideal companies, unable to attract new capital to get back to growth, the future is bleak. For some, the only respite is that their debt burden is phased out a few years into the future (Figure 2, with thanks to Sarath Devarajan who first pointed this phenomenon out to me). That respite may not be enough for those unable to meet interest payments or falling way out of debt covenant boundaries. Moreover, a prior lack of prudence in “booking” reserves with optimistic estimates of ultimate recoveries (EURs), has made it likely that many companies will have to write down these assets, thus further stressing the balance sheets. As I suggested for Whiting Petroleum, perhaps the solution for bankrupt and ready-to-be bankrupt zombie firms is for the banks to herd them together as a carefully managed and depleting asset set, managed to repay as much of the outstanding debt as possible over a period of years.
Transformation, disruption, and consolidation of the US upstream is only the first step that the industry needs and energy policymakers ought to support for the energy and economic future of America. I outlined four other steps that the industry and policymakers must consider to enable a successful energy transition in my “Five Brutal Facts” article. I hope to discuss those steps in more detail in future posts.