For the thousands of new entrants into the oilfield services (OFS) industry in the past 15 years - both workers and companies – if you didn’t know what senior secured lending covenants were a year ago, you sure do now. Whether your vehicle has been repossessed, your company is surviving on covenant waivers, or you or one of your competitors have been forced into receivership, OFS is getting a crash course on the downside of credit, banks and borrowing. Lenders want their money back and the oil price collapse has crippled your ability to make the necessary payments. Who knew when you signed that loan agreement things would deteriorate to this point?
As the Canadian oilpatch enters its second year of very tough times, much has been written about debt and the problems associated with carrying too much of it. Whether exploration and production (E&P) or OFS, publicly traded companies considered ‘’over-levered’’ have had their share values clobbered. A growing number of companies are being forced into receivership because their lenders have determined meaningful capital recovery the old fashioned way (make the principal and interest payments) is hopeless.
Some borrowers offside on their lending covenants are on their third or fourth round of relief through forbearance letters or equivalent, something parties on both sides of the transaction hoped would no longer be a problem in 2016. While the rules governing how borrowers and lenders ought to interact with each other have been around for decades, in the current market not everyone is exactly sure what to do next.
Many new borrowers are enduring a painful education on the legal implications of the lending documents they signed. Hidden in the small print and legalese is the fact that when the loan was accepted - whether a capital lease or senior secured credit facility - either your assets or your company are technically not yours until the debt obligations are repaid in full. When you can no longer make principal or interest payments, you no longer have any legal claim to the collateral, whatever that may be. Depending on what you borrow and the terms and conditions, for private owner / operators it could be your life’s work. Few, if any, figured their investment and sweat equity could one day be worth nothing when they signed the loan papers. Related: Three Stocks Well Positioned For An Oil Price Rebound
Lenders, on the other hand, have been forced by market circumstances to redefine flexibility. The rapid and mono-directional decline of upstream oil and gas revenue, cash flow, liquidity and asset values has all but overwhelmed suppliers of debt capital. Macroeconomic conditions have deteriorated much more quickly than either borrowers or lenders have been able to adapt to. Instead of flexing their muscles and exercising their security to recover their capital, Canada’s six largest banks, for example, are more inclined to focus on explaining how only a small percentage of their total asset base (remember your liability is your lender’s asset) is exposed to the oil and gas industry.
Reams have been written about public companies violating their lending covenants and the lengths to which their lenders have gone to keep their client companies alive. Forced or negotiated asset sales and equity issues to pay down debt are common. Better to try to make the current situation work if possible than face certain losses in the case of forced liquidation. Nobody who employed debt capital markets to grow their company in the past had any idea some of the current lending terms were available.
Canada’s big six banks have been kicking the can down the road for over a year. Finally, in the first reporting quarter ended January 1, 2016 the Bank of Montreal, Royal Bank of Canada, Toronto Dominion Bank, Scotiabank, Toronto Dominion Bank, Canadian Imperial Bank of Commerce and the National Bank jacked up their loan loss provisions while providing detailed disclosure of the extent of their oil and gas loans. Big numbers.
In total, these six Canadian banks have committed loans of $49.8 billion, not all in Canada. OFS is in there for $5.6 billion. According to a March 2 Bloomberg Brief on bankruptcy, these six banks had undrawn credit facilities that brought the total to as high as $107 billion, as well as a total provision for Non-Performing Loans (NPL) in the quarter of $259 million. Related: Why Saudi Arabia Has No Intention To End The Oil Glut
The amount is significantly higher than the $215 million total for the six banks for the entire fiscal year, ended October 31, 2015. This is surely because oil markets and the health of the industry has continued to deteriorate since that time. News reports caution a growing number of oil and gas based companies are on so-called “credit watch.” Because of current oil and gas prices and low OFS activity, the next round of loan covenants tests will surely increase the amount of debt in the NPL category.
Many comparisons have been made between the current downturn and the 1980s. When it comes to debt, the 21st century looks rock solid. In his excellent and exhaustively researched 1983 book Other People’s Money-The Banks, the Government and Dome (Petroleum Ltd.), author Peter Foster noted four Canadian banks – CIBC, TD, BMO and RBC - had combined exposure of $3.1 billion to Dome Petroleum Ltd. in 1982, nearly half of Dome’s $6.7 billion in debt. Corrected for inflation in 2015 dollars, using Statistics Canada Consumer Price Index Data, this is equivalent to $7.3 billion and $16 billion respectively. For the four banks this is about 25 percent of current total E&P loans outstanding; just to one company! Back in the 1980,s two Alberta banks – Canadian Commercial Bank and Northland Bank – went broke because of their bad energy loans and the impact the downturn had on the entire Alberta economy.
So, although borrowers may be in trouble this year, it doesn’t appear they will be taking any of the chartered banks down with them. That said, bank loans are only a fraction of the total debt carried by the Canadian oilpatch. There are lots of equipment leases and subordinated, interest-only (for now) bonds not listed in these figures.
The number one question for OFS managers and operators is whether or not their lender is going to classify their debt as a NPL. When the loan is no longer on the books of the parent company as an asset, the loans and / or credit manager treats the file differently. Definitions of NPL vary but the International Monetary Fund’s is clear: “A loan is nonperforming when payments of interest and principal are past due by 90 days or more, or least 90 days of interest payments have been capitalized, refinanced or delayed by agreement, or payments are less than 90 days overdue but there are other good reasons to doubt that payments will be made in full.” Related: Exposing The Oil Glut: Where Are The 550 Million Missing Barrels?!
Many borrowers have received a hall pass on their principal payments in the past year through covenant waivers. But personal experience (your writer has seen some tough days at the office since buying his first oilpatch-related business in 1979) is the demeanor of the lender changes sharply when the borrower can no longer pay interest. That means the company is bleeding cash and is going out of business as the balance sheet and collateral base supporting the loan deteriorates. With no overall oil price or activity turnaround on the horizon (based on public announcements, spending plans on E&P CAPEX in 2016 will be substantially lower than in 2015), lenders are faced with making the unpleasant decisions they have avoided for a year.
Even a recovery will not get the total pie for OFS back to where it was. If oil were to return to US$100 tomorrow no greenfield oilsands construction will take place until issues around export pipelines accessing tidewater are resolved. Once the current oilsands projects are completed, this will leave a $15 billion-per-year cavity in future capital expenditures, some 20 percent of total business. Even if WTI rose to US$50 or US$60 a barrel later this year, the activity and spending to support all OFS companies which were thriving in 2014 will not be there.
Cheap debt capital is a wonderful thing so long as it can be serviced. E&P companies borrowed extensively to keep drilling and spending. OFS borrowed aggressively to build new generation rigs and service equipment and add capacity. But the ability of any company to borrow is based on their capacity to repay, defined in the simplest terms as free cash from operations. Even if commodity prices and business were to pick up tomorrow, the ability of clients and suppliers to borrow will be harshly curtailed because of their trailing cash flow.
This is why lenders have OFS in such a precarious position. There is the issue of servicing and repaying current debt, plus the reality that debt capital required to exploit the recovery (working capital, refurbishing parked or scavenged equipment), when it comes, will be restricted.
Many analysts who don’t understand how this business actually works claim the moment oil prices rise high enough, the light tight oil drillers in Canada and the U.S. will go right back to work and re-flood the market with more supply. Not likely, certainly not in the short term. There will be a continuation of the current industry-wide cash flow and credit crunch which will impair the speed of the recovery if and when it takes place.
There is said to be lots of capital on the sidelines looking for deals. OFS owners and managers up against a debt wall should consider finding some.
By David Yager for Oilprice.com
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