Everything Goes Wrong at Once for Distressed Energy Debt Issuers
Allison McNeely
Mar 10, 2020 — 2.43pm
Energy bonds plummeted Monday to record lows, some of them with extraordinary drops of 10, 20 or even 30 cents on the dollar. The average spread over Treasuries for companies in the Bloomberg Barclays High Yield Energy index has surged above 10 per cent for the first time since 2016, back when hundreds of energy-related companies were going bust or restructuring.
That last round of rejiggering was supposed to stabilize the industry's future by cutting debt and extending maturities for almost a decade. But coronavirus and the disintegration of the OPEC alliance has cast doubt on whether oil and gas drillers can keep paying their bills that long, let alone repay the debt.
The amount of oil and gas debt trading at distressed levels jumped 14 per cent on Monday, to $US81.5 billion from $US71 billion on Friday, according to data compiled by Bloomberg. Energy services debt trading at distressed levels rose about 26 per cent to $US10 billion. This is how we got here:
Didn't energy companies push off bond maturities to 2022-2025?
Yes, during the last downturn that began in 2014, many survived by persuading creditors to swap their holdings for new, longer-dated maturities, or by converting unsecured bonds into stock.
But that often meant promising hefty new interest rates, with cash flow models based on oil prices above $US50 to $US55 a barrel. Some of those promises were aggressive even back then, and now they are utterly unsustainable at $US30 a barrel. In that scenario, the longer maturity doesn't help because the issuers may default long before the due date.
So they're safe if they keep paying the coupon?
Not necessarily. Dwindling earnings and cash flow has put borrowers at risk of violating the terms of their debt, such as covenants that require a company to keep leverage below a certain threshold. A breach could be considered a default. With the outlook for energy prices so weak, creditors may be less willing to grant waivers and instead use the default to push companies into bankruptcy.
Will bankers bail them out?
That seems less likely this time. Banks typically provide loans that are backed by the company's oil reserves and other assets. The value is reassessed twice a year -- or redetermined in industry parlance -- and the size of the company's credit line is adjusted accordingly.
As the price of oil declines, those reserves become less valuable, putting borrowers at risk of having their credit lines trimmed. That means less money for operations that might generate cash for bondholders. Industry watchers are expecting credit lines could be cut by 10 per cent to 20 per cent this spring.
An added pitfall is that when a company's finances get shaky, a bank can demand to reassess the assets four times a year, doubling the chances of a setback. In the worst-case scenario, a credit line can be cut below the amount already outstanding, meaning the cash-strapped company must pay back the balance. Unless the bank stretches out payments, that's a recipe for instant insolvency.
The decision doesn't necessarily rest with the bank. They typically don't want to push a company into bankruptcy -- bankers aren't in the business of running distressed oil producers. But post-2008 financial crisis regulations limit how much risk they can take on.
Could private equity and hedge funds step in to provide credit?
Yes, although they may not want to. Credit funds saw their returns thwacked by energy in 2019, after the sector saw the highest bankruptcy rate since the height of the 2015-2016 downturn. Credit markets have largely remained closed to energy borrowers and private equity has been reluctant to finance companies because they are having trouble getting out of their existing investments. Unless oil can stay above $US55 for an extended period of time, there are few buyers of energy companies and assets.
How bad can it get?
If this keeps up, pretty bad. The current downtown is reminiscent on the 2014-2016 downturn, which saw the largest wave of energy bankruptcies in history as credit spreads approached 1800 basis points, Spencer Cutter, a Bloomberg Intelligence credit analyst, wrote in a Monday note.
"'The plunge in oil prices may drive a wave of bankruptcy filings, starting with with the spring borrowing-base redetermination process," he wrote.," he wrote.
Law firm Haynes & Boone's tally of industry bankruptcies shows more than 400 oil and gas producers, service companies and midstream operators went bust between 2015 and the end of 2019.
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