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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Why The Right Financing Matters More Than Ever

As the price of oil has cratered, traditional financing alternatives across the energy industry have started to dry up. Where financing for new projects was once predominately bond issues, bank loans, and perhaps occasionally secondary stock offers, today energy companies increasingly need to look for new sources of project funding. Increasingly, financing today is coming from hedge funds, private equity shops, and even family office investments. Even publicly traded firms today are finding that they cannot access funding at favorable terms anymore.

Energy industry participants need to understand the new funding models and alternatives that those funding options create. In particular, private equity firms are increasingly interested in offering funding even to distress companies in the oil patch. Many of these same firms are essentially shut out of the high yield debt markets as the default rate on high yield energy bonds may move to as much as 10% next year.

The funding conundrum is being exacerbated by periodic bank revaluations of credit lines. While the fall revaluations in October were not as bad as some experts had forecast, there is little doubt that credit spigots have tightened dramatically. Companies that were spared the indignity of a credit line cut in October cannot rely on that same level of credit being available in as little as six months, let alone several years.

In the face of this situation, energy executives have to consider the alternatives. For those seeking equity financing, private equity deals are the cleanest route. Whiting and other firms that tried did secondary offerings earlier this year, saw their shares hammered following those secondaries. Part of the problem with private equity thus far has been a dramatic gap between bid and ask prices for assets. That gap appears to be starting to close.

Private equity firms have raised massive amounts of money in recent months and now are looking for potential investments. This has made many funds more willing and eager to cut deals with prospective investment companies thus lowering asking prices on deals. At the same time, it has become obvious to many energy firms that this will not be a V-shaped recovery in oil prices which has made firms more willing to accept lower valuations on their assets. There is still some haggling over valuation of course, and not all executives are ready to talk about making deals, but the market does seem to be thawing slowly.

Finding financing can be critical for many firms looking to take advantage of new opportunities. Weatherford recently looked to raise funds to take advantage of assets being shed in Baker Hughes/Haliburton merger, but then subsequently dropped those plans. While the asset sales appeared to represent intriguing an economic opportunity, the capital cost was simply too great, and the effect on WFT’s stock was too draconian. The firm subsequently announced they were not going to bid on the assets and would focus on improving the core business instead.

For investors and executives who are holding out hope of a strong recovery in oil prices, debt financing may be a better alternative than equity financing. Financing does not have to be either debt or equity of course – it can be a combination of the two, and especially for smaller firms, this may be an excellent option. For instance, business development companies are looking at the oil patch and appear willing to consider even small deals involving combinations of debt and equity.

Executives who are uncomfortable issuing any equity in the current environment should still consider debt choices. Prices on that debt may end up being high enough to give some executives heartburn. For instance in one recent deal, a firm sold $530M in five year senior secured first-lien notes at a 13% rate. That level of cost for shorter term funding is far from optimal, but if oil prices do stage a sharp recovery, the use of debt over equity will look sage indeed.

Another alternative the energy firms may be able to look at for financing especially when dealing with private equity investors, is convertible securities. There have been several deals done in that arena of late including a recent deal by Chesapeake. The advantage with convertibles is the ability to partially offset some of the cost of traditional debt funding with a modicum of embedded equity optionality. The exact mix of equity option versus debt cost obviously varies from firm to firm, but it’s an opportunity worth exploring.

For investors looking to capitalize on the opportunities in the energy space right now created by the lack of traditional funding options for energy companies, one interesting choice is Cimarex Energy (XEC). XEC has been outperforming all year long thanks to minimal leverage and very impressive operating performance especially given that the firm started with minimal hedging in place for 2015.

Cimarex did a secondary offering in May 2015 and the stock responded negatively. Since that time the company has been stuck in neutral despite having a rock-solid balance sheet after that offering. Of course, in the current environment, an energy stock that is just treading water is outperforming most of its peers. XEC is a good investment choice in the current financing environment since the firm has a lot of assets that are early in their lifecycle which could be sold to private equity firms if future funding needs arise. Smart investors should study the company carefully.

Finally, it is worth remembering that sometimes new financing can actually make a company safer and be a smart investment in the future. This is in stark contrast to the traditional view that additional financing increases risks for shareholders either through levering up or diluting existing owners. If additional financing helps shore up a balance sheet and prevent a fire sale on assets, then it can behoove both existing shareholders and bondholders to raise more cash. In some cases, markets may even reward companies for making the tough choice and raising capital if it helps preserve the business. Callon Petroleum Co. witnessed exactly that when it recently raised funds through a secondary offering to take advantage of emerging opportunities. While the market’s initial reaction was negative, with proper framing of the news the stock has moved higher in subsequent weeks since the secondary was announced demonstrating that even in today’s markets, smart executives know there are still ways to raise value-additive capital.

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