Chinese companies have been a major acquirer of Canadian oil & gas companies as they look for a strong presence in the country with the 3rd largest oil reserves in the world. From 2010 – 2013 Chinese companies made significant acquisitions in Canada from Sinopec’s (SNP) 9 percent stake in Syncrude Canada to China National Offshore Oil Corporation or CNOOC’s (CEO) acquisition of Nexen.
As oil prices fell from over $100 per barrel in 2014 to $40 per barrel in mid-2016, it seems that Chinese firms began regretting their purchases – buckling down with a phase of cost cutting, capital postponement, and layoffs to preserve investments. While reeling from investments made at the height of the oil market, Chinese companies have not abandoned Canada’s oil & gas sector; instead, these companies are starting to approach oil investment from a value perspective. Chinese companies are being less speculative and more conservative in the price they are willing to pay with the expectation of unlocking wealth.
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Chinese companies have executed this value strategy recently by targeting oil & gas companies on the verge of bankruptcy. These Canadian companies control significant oil & gas resources and infrastructure.
Several Canadian oil & gas producers continue to lose money with oil prices under $50 per barrel; they are unable to raise funds through equity or debt issuance and are already approaching default on senior credit facilities and long-term debt.
A Long Run Play on Canada’s Montney
The first to fall victim to a Chinese company’s predatory value acquisition as oil prices fell was Long Run Exploration (LRE.TO) at the end of 2015. Long Run Exploration was a company that had levered itself with cheap debt to acquire production and turn itself into a high yield dividend paying producer. From 2012 -2014 Long Run increased production by 236 percent, but had increased its debt by 283 percent. Building Long Run on cheap debt was sustainable in 2014 when WTI prices averaged $93 per barrel, but when prices fell to under $50 per barrel in 2015 Long Run started to unravel.
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Long Run was hemorrhaging cash in periods of high oil prices and as prices fell in 2015, the company was temporarily saved by hedged oil & gas production (locking in future oil prices). Those same hedges were not in place in 2016 and as WTI hit $40 per barrel Long Run went from making $CAD 90 million in 2015 to potentially losing $CAD 50 million in 2016.
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To protect itself from collapsing prices, Long Run had to force production costs down by 19 percent, reduce its capital program, and completely cut its dividend. Long Run’s efforts were in vain as the company was about to fall under the weight of its debt load as default was pending.
In Comes the Chinese Suitor
Sinoenergy Investment, a Chinese company, took notice of Long Run’s predicament as a new opportunity to invest in value. Sinoenergy had made a previous purchase in a Canadian oil & gas company, New Star Energy, in July 2015 that cost the company $CAD 57,778 per flowing barrel and $CAD 13 per barrel in the ground (Proven & Probable reserves or 2P reserves). Sinoenergy’s purchase of Long Run Exploration was much more conservative; the Chinese company paid less than half the price per flowing barrel and barrels in the ground.
Sinoenergy offered $CAD 0.52 per share in cash to equity holders, but decided to undercut subordinate debenture holders to 75 percent of their initial loaned amount. This returned $CAD 100 million to equity holders and $CAD 56 million to subordinate debenture (unsecured debt) holders.
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The fact that Sinoenergy had the cash to offer equity holders, but was unwilling to give subordinate debenture holders full payment made this a risky purchase. With limited alternatives to fund operations and a pending default, bankruptcy was a possible outcome for Long Run that would pay out the capital structure from top to bottom. In the case of default it was not likely that subordinate debenture holders would recoup their entire initial loan; therefore, Sinoenergy saw an opportunity to exploit uncertainty in the oil & gas market. Related: Activist Investors About To Shake Up The Oil Patch
Instead of the long process, excess costs, and uncertainties of bankruptcy that could potentially result in a lower portion of subordinate debentures paid back, Sinoenergy shortened that process and brought certainty to shareholders and debenture holders with a cash offer. The Chinese company would essentially help Long Run avert bankruptcy by purchasing the company prior to any proceeding into bankruptcy. This method allowed Sinoenergy to payback a portion of subordinate debentures which, in the event of a default and bankruptcy, would likely result in a similar outcome.
Pushing the Envelope
Now a Hong Kong based company, Reginwood Group, is pushing the limits of value acquisitions of Canadian oil & gas companies on the verge of bankruptcy. A Canadian oil & gas producer, Twin Butte Energy (TBE.TO), has suffered from the same outcome as Long Run Exploration: leverage, high dividend payouts, and overspending.
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Similar to Long Run, Twin Butte took the steps of cutting production costs, reducing capital programs, and cutting its dividend. However, unlike Long Run, Twin Butte was already on the verge of default and coming out of default was very unlikely. Twin Butte would need oil prices to rebound to $85 per barrel before 2017 to hopefully avoid default. Related: Why The UK Postponed This Nuclear Megaproject
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The Hong Kong based Reignwood Group saw this as an opportunity in a way that is similar to Sinoenergy’s case to purchase Long Run Exploration; however, Reignwood offered a much lower acquisition price for Twin Butte.
Reignwood is undercutting subordinate debenture holders by offering 14 percent of their initial loan value. This significant discount for subordinate debentures means Reignwood will pay $CAD 12 million to subordinate debenture holders, but offer equity holder $CAD 21 million.
Twin Butte is unlikely to pay off debt with its current reserves and debt holders seem to be unwilling to give any value to equity holders in a sale of the company. Since the announcement of the Twin Butte acquisition, certain subordinate debenture holders are requesting a better deal and plan not to approve the acquisition. A majority (66.7 percent) of equity and subordinate debenture holders have to agree to the acquisition by Reignwood on August 10th, 2016.
With the closed acquisition of Long Run Exploration and the pending acquisition of Twin Butte Energy, a precedent has been set, which is that in the present market subordinate and unsecured debt is about as safe as equity.
Unsecured Debt – A Fragile Security
As WTI pricing remains under $50 per barrel we are likely to see more levered companies encounter issues similar to Long Run and Twin Butte. Recently Penn West Petroleum (PWE) had run into debt issues and had to sell $CAD 975 million of its core Saskatchewan Viking assets to Teine Energy. Penn West used funds received to pay back part of its $CAD 1.9 billion in debt, thereby avoiding the potential of selling itself to a predatory acquirer and at a significant discount like Long Run and Twin Butte. Another company that is caught between a sale and restructuring in order to stave off bankruptcy is Lightstream Resources (LTS.TO).
Already reeling from debt issues, Lightstream had to restructure its $800 million in senior unsecured debt by taking $465 million of that debt and converting it to $395 million of new second lien senior secured debt (behind Lightstream’s first lien credit facility). Lightstream would raise an additional $200 million in second lien senior secured debt in order to reduce the debt on its higher ranking credit facility. Remaining senior unsecured debt holders were furious as their bonds fell in rank and in price behind Lightstream’s credit facility and second lien senior secured debt.
Currently, Lightstream has missed its $32 million semiannual senior secured debt payment for 2016, which puts the company in default. The company’s options to generate cash included a sale of assets, sale of the company, or a company restructuring. Lightstream has chosen to restructure the company and bring debt down by 73 percent and annual interest payment down by $86 million.
Lightstream’s restructure would convert common shareholders to a 2.25 percent ownership of equity in the new restructured company, senior unsecured debt holders will own 2.75 percent, and second lien senior secured debt holders would own the remaining 95 percent. Lightstream needs the approval of 66.7 percent of shareholders, secured debt holders, and unsecured debt holders voting separately on September 13th, 2016. If the agreement does not go through, Lightstream will have to sell itself under the Companies’ Creditors Arrangement Act. If the company is put up for sale and reception is weak, Lightstream may be susceptible to predatory acquisition.
In this sustained decline in oil prices where companies are trying to fend of default and potential bankruptcy, it seems that unsecured debt is about as safe as equity in a predatory acquisition market. As Chinese companies use this environment to build up a larger portfolio in Canada’s oil & gas sector, other oil & gas companies and private equity funds may smell opportunities and soon follow this acquisition strategy. For companies in debt troubles, unsecured and subordinate debt holders beware! It will be important for debt holders to determine how much unsecured and subordinate debt holders will receive in bankruptcy. Unsecured and subordinate debt holders must make sure any predatory acquisition pays off an amount that is at least equal if not greater than the payoff after bankruptcy proceedings, as payoffs move down the ladder of debt holders – from the most senior and secured to the most junior and unsecured.
By Omar Mawji for Oilprice.com
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