Have you heard of “falling knife” securities? As the picturesque term suggests, buying into a market with strong downward momentum can be injurious to the portfolio. However, if timed correctly, just as the next upswing in prices begins, the purchase can be a clever way to buy underpriced stock.
Nearly two years ago, oil & gas prices started falling, leading to a host of solvency issues for exploration & production (E&P) companies, also known as the upstream petroleum industry.
Lending to companies within a distressed sector also is as tricky as catching a falling knife.
However, there is a way for such companies to “unlock cash from de-risked assets, and deploy it in higher risk opportunities,” said Mark Sherrill, Partner at Sutherland Asbill & Brennan LLP. He was the second of two speakers at a webinar sponsored by the Global Association of Risk Professionals on June 7, 2016.
Sherrill described one way financial markets could offer relief to affected oil & gas companies: through reserve-based lending (RBL), which is an asset-based financing mechanism.
RBL differs from other project loans, he said, because it involves more than one asset. There are assets that are developed to the production phase already, and these are considered “de-risked.” These de-risked assets can be used as collateral on loans to the other, riskier, part of the business.
Sherrill said there are twice-yearly redeterminations of the borrowing base. “Lenders can choose to protect themselves by reducing the borrowing base,” he noted.
Other factors exacerbate the effects of redetermination, such as hedges expiring, and pressure from regulators. “There are reports of the FDIC and OCC warning banks to limit exposure to the oil & gas sector,” he said. “Lenders are caught between a rock and hard place.”
He described other financing available in the oil patch, beyond the traditional corporate loan facility. There can be second lien or junior facilities; mezzanine loans, bridge loans; or high-yield bonds. “Typically, loan covenants are based on indicators trailing by 12 months, therefore the pain might not show up right away.”
Sherrill closed with a section on the bankruptcies in the E&P sector, where there is less available debtor financing. “Existing lenders do not want to take on collateral,” he said, and potential buyers are “still waiting on the sideline.”
Path 1 is a quick, distressed sale, such as that done for that Quicksilver Resources, which had around $2 billion in assets. An out-of-court auction was held, and the highest bid was determined by the debtor.
Path 2 is a pre-packaged bankruptcy with a debt-equity swap. This can occur “in just a matter of weeks,” he said, and the shortened time span holds costs down. One caveat is that the pre-packaged plan “could be held hostage by unsecured creditors,” who may hold up the proceedings until they can get more return.
“Most E&P debtors have been small- to medium-sized producers,” he noted. “Compared to the oil bust in the 1980s, there is now more beneficial treatment of royalty owners and working interest holders.”
In summary, providing loans in a sector with strong downward momentum (such as oil & gas in mid-2016) can be injurious to the lender. It’s helpful to know what steps can be taken to help a company get past the bad stages, and Mark Sherrill provided useful descriptions of RBL and redeterminations. ª