Shale Bank: a business model and plan to optimize recovery from bankrupt US E&P assets

Frontispiece: It feels inevitable to some industry observers that the bankruptcies of companies like Whiting and Chesapeake will only result the same old cycle of Chapter 22s.

In recent thought pieces on the causes of financial distress and hence post-coronavirus future of the US E&P industry and the Whiting Petroleum bankruptcy, I alluded to a business model driven by the owning banks to consolidate assets and drain them of cash, with capital reinvestment occurring only in the strictest of circumstances. In this article, I describe the model in some more detail.

The opportunity

Chesapeake recently became the latest casualty of an implosion of the US E&P sector, a disaster, years in the making, but triggered by prolonged low prices because of the Saudi price war and more so coronavirus demand slump. So far in 2020 nearly $20 billion of debt has gone to the wall, the money originally borrowed against booked oil and gas reserves, to acquire or drill more reserves. In most cases the original shareholder equity is worthless, and the assets are now owned by groups of banks. A familiar pattern has emerged over the last decade for shale cos to go bankrupt, re-structure, and launch again, often with the same management and boards as before. Some entities have gone bad again, with the term Chapter 22 coined to describe companies that process Chapter 11 bankruptcy twice! It seems that banks often think that sticking with the same management team is their best bet to get (some) of their money back, or don’t have the wherewithal to figure out a different course of action. Here’s a different approach.

Figure 1: Outline of the governance model for Shale Bank.

Seize and pool the assets

This first step involves firing the existing management team and board, liquidating the company, and transferring the assets into a new entity which I will call Shale Bank. Shale Bank will be a private entity and the original equity holders will be the group of creditors on the bankruptcy, their percentage holding proportioned by their share of the debt. A brand new management team and board will be put in place to manage the assets - I will say some more about that governance later in the piece.

Cash is king

In Shale Bank, the most important financial account is the statement of cash flows, then the financial position or balance sheet. Shale Bank will manage quarterly cash flows to be always free cash flowing. In other words, cash from operations will always exceed cash used in investing activities or financing activities (for example paying dividends). There will be little or no debt in Shale Bank, with the possible exception of a revolving facility to manage short term liquidity. The financial goals of Shale Bank are to maximize cash distribution to shareholders from depleting and depreciating assets while setting aside funds to cover asset retirement obligations (well and facility abandonment and restoration). Asset disposals will likely for part of the cash realization of Shale Bank. Although Shale Bank may also contain lower decline conventional assets, the “base case” financial forecast is for Shale Bank to shrink quite quickly over five or years or so and close.

Every $ counts in operations, but not at the expense of integrity

Shale Bank assets will probably be grouped by geography which will likely also characterize the production and financial performance of the assets. Asset managers (AMs), reporting to the Operations Director, will have lean technical teams (at least partly staffed from the bankrupt entity) to manage day-to-day cash flow i.e. revenue - LOE - production tax - gathering and transport. AMs will have no capital expenditure authority, except when provided by the Investments Director. Wells that are not producing positive EBIDTA or have no prospect to do so on the basis of 6 months price strip are shut-in or sold. Environmental performance is critical, as is asset integrity, and measures of safety, leaks, GHG emissions and so on set will be trigger points for any bonuses to be paid to all Shale Bank employees, including the executives

Disciplined investment

There will be assets in Shale Bank that will deserve reinvestment. Investment will occur in a very disciplined way and be the purview of the Investments Director to management capital investment to priortise the most deserving projects across the portfolio. New projects will be judged on their ability to perform at floor oil and gas prices, their capacity for cash generation, and investments will only be made if the company is sufficiently cash-rich to do so. Shale Bank is unlikely to invest in longer-term multi-quarter let alone multi-year projects. Investments may range from new drilling programs to technology investments to enhance efficiency and reliability and hence cash generation. The Investments Director will have a small team to assess investment opportunities across the assets. The Investments Director and Managing Director will have a clearly set delegation for investments, above which it is a board decision.

Corporate Social Responsibility

Shale Bank’s primary responsibility to the community is to leave the assets properly decommissioned and the land restored or hand the assets over to responsible owners for their late life. The Asset Retirement Obligations on the balance sheet of Shale Bank will be increasingly offset and ultimately matched by a fund of securities and other low-risk investments in lower carbon businesses and technologies. The fund manager, who may be a contractor to Shale Bank, will report to the finance director.

New deposits to Shale Bank

Assets can be added to the company by other entity owners who will derive equity in Shale Bank in proportion to the value of the new assets relative to the existing asset base. The valuation of assets (and associated liabilities) will be always completed in the same conservative (prudent) manner. The Investments Director’s small but expert technical team will be responsible for consistent and reliable adherence to those standards. The benefits of consolidation and the economies of managing assets at scale will come through to equity holders proportionately to their holding.

Governance

The management team reports to an independent board of directors who in turn report to the shareholders through quarterly and annual processes. There is a clear definition of roles and responsibilities of the management team and board, including clarity on matters held for the board, and matters needing shareholder approval. The Managing Director and the Finance Director should be members of the board, but the Chair will be independent, and there will be sufficient independent directors to always have the board independent in total. The selection and succession of the Board and executive directors will be matters for shareholder approval. Purpose, strategy, and plan will be developed by the Board and executed by the executive directors. Although a private company, Shale Bank will be biased towards transparency in its reporting of performance in all aspects, as part of its commitment to corporate social responsibility. Directors and employees of Shale Bank will have a fairly generous base salary compared to the market, but variable schemes will be limited or minor (Class B?) share ownership on which distributions are only made only if the financial and social responsibility goals are achieved.

Shale Bank’s future

Although I’ve described a declining and depleting future for Shale Bank, I can also see the possibility of a longer life with a deeper purpose for the company. For example, the maturing technical and financial expertise and discipline of managing shale and other oil and gas assets might allow the further application to acquired assets as apposed to assets deposited by creditors. Moreover, Shale Bank may be able to evolve in its purpose and diversity of asset class to become an energy firm of the future, able to broaden its societal purpose and distribute returns to shareholders.

Getting started

To break the cycle of Chapter 22s, a group of creditors must decide on a different course. This is a matter of disruption for sure, but eggs have to be broken to make an omelet.