Remember 1974? Those of us who do can recall the pain that ensued after overseas oil producers put the squeeze on production. Gas soared from 29
cents to a whopping dollar per gallon. Lines of cars snaked down the highways from any gas station that actually had gas, and drivers were only allowed to refuel on certain days, based on the digits on their license plates.
Times have certainly changed.
For the second year in a row, Energy and Resources is at the top of AlixPartners’ annual Restructuring Experts Survey’s list of “Sectors Most Likely to Face Distress.” This online survey was administered in November 2015 to 185 high-level North America-based corporate restructuring experts, including attorneys, investment bankers, lenders, financial advisors and hedge fund and private equity managers. This year’s report is titled “Energy in Distress,” and 86% of the respondents picked Energy and Resources as the number one industry to feel distress, compared with 70% a year ago.
John R. Castellano, an AlixPartners managing director who specializes in turnarounds in the Energy Industry, spoke with ABF Journal to explain the source of the current upheaval in the energy industry and offered some predictions related to the future of the distress and its impact on ABL lenders.
“Five years ago, no one believed that oil would break $40 a barrel,” says Castellano. “Now we’re down to $25 to $30 a barrel and no one knows when it’s going to break.” As of this writing, the price of WTI (West Texas Intermediate) crude oil was $30 a barrel and still in freefall.
Although it is tempting to see the energy industry as a monolithic whole, Castellano explains that it is divided into five segments:
- Upstream: Exploration and production
- Midstream: The pipeline
- Downstream: Refining and bringing the product to market
- Support Segment: Provides services to the first three
- Offshore: Drilling suppliers
“The upstream and the offshore are currently feeling the most pain,” he says. “The refiners are doing very well. Their input is the crude oil, and the demand has not dropped.”
So why are we suddenly swimming in oil?
U.S. Drives Up Oil Supply
“What has changed,” Castellano says, “is our country has driven the supply up. Five years ago, we were pumping 4 to 5 million barrels a day. Now it’s 9 million barrels — that’s double our production. China used to purchase our excess supply, but with the economic slowdown there, they are buying less.”
The U.S. is flooding the market? When we were sitting in those 1974 gas lines, none of us believed that the U.S. had any oil left to pump. What changed?
“Over the course of the last 10 years, there has been significant improvement in the technologies associated with exploration and development of unconventional oil fields,” Castellano explains. “In addition to significant advances made in geological and seismic analysis to identify hydrocarbon deposits, significant advances were made in developing well structures for tight oil formations with the use of horizontal drilling and hydraulic fracturing.
“These advances allowed for development and production from fields that were relatively unknown in the U.S. as having a significant amount of oil in place. For example, the Bakken in North Dakota and the Marcelleus in Pennsylvania became overnight sensations once new techniques were applied.”
This technology was initially applied to natural gas fields around the turn of the century and was applied to oil fields shortly thereafter. As a result, our country hit a low in September 2008 with daily crude production at less than 4 million barrels of oil per day, which more than doubled to over 9 million barrels of oil per day by 2015.
Although being dependent on foreign oil always had a political component, today’s global economy, combined with increased instability in the Middle East and Russia, has had a stronger impact on supply. For example, sanctions have been removed from Iran, so it is exporting oil. Iraq, no longer under the thumb of Sadaam Hussein, is exporting oil. For the first time since 1975, U.S. oil companies are free to export oil since Congress has lifted the ban, and they will be looking to sell oil to Europe now that China has cut imports. This will free the rest of Europe from dependence on Russia for its oil.
For 40 years, OPEC, the oil cartel originally formed by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, kept a stranglehold on output to control prices. Consumers monitored OPEC meetings, waiting to hear what the organization would be charging per barrel and how many barrels it would pump, knowing it would directly affect gasoline prices. Today, many find it puzzling that, despite falling prices, OPEC is not tightening the spigot.
“People suspect that OPEC is taking the position ‘we want to drive as many people out of this business as possible,’” says Castellano. Here, too, the improved technology is allowing for the proliferation of energy companies, which have mushroomed over the past decade, contributing to the glut.
Start-Up Oil Companies Flood the Market
Castellano points out that most of the companies in the downstream and offshore segments of the industry are not legacy companies like Mobile or Shell. In a way, the energy sector is like the tech sector was in the ‘80s, with companies starting up on a shoestring and crowding the market. “These companies are start-ups. They don’t have profit controls in place. Lenders were throwing money at them. They are still highly leveraged, which was okay when oil was $50 a barrel. But at $30 a barrel, it’s a problem.”
As a turnaround consultant, Castellano advises these companies to address their operating costs. “They need to determine the bare minimum they need to keep going. We say, ‘You need to start a zero-based budget.’”
Months of Instability Lie Ahead
Castellano sees another 24 to 36 months of volatility in the market — even more if new political turbulence further impacts global prices. He predicts that as energy companies try to find protection in Chapter 11 and lenders are forced to become equity owners, there will be a push to reorganize followed by a round of mergers and acquisitions.
“A lot will depend on the appetite of the lenders. These are not loan-to-own lenders. They were anticipating getting paid back, but this prospect is getting dimmer as the price of supply is eradicating. They will want to modify their investments as they won’t want to become equity lenders. I think there are a lot of companies that won’t survive.”
Castellano predicts that many ABL lenders “will still be able to survive because they sit at the top of the structure. The debt below that will have to be structured, and those lenders will have to take equity in these companies. That may not happen to the ABL lenders.”
Regarding other types of energy, Castellano says that the focus is primarily on oil in distress. Natural gas prices, he points out, have been depressed for the past 10 years because of abundance in the market produced by fracking. Coal prices are also depressed because with abundant natural gas and oil, coal has been less appealing to consumers seeking a less expensive option.
The future of renewable energy is more mixed. Lisa Donohue, also a managing director at AlixPartners, contends, “Low natural gas prices are also negatively impacting power and energy, solar, and renewables as the economic choice for clean energy is currently less compelling.”
But the U. S. Energy Information Administration sees a different picture. According to its recent Short Term Energy Outlook, the market share of renewable energy is increasing. Forecast share of total generation supplied by hydropower is up from 6% in 2015 to 7% in 2017, and the forecast share for other renewables has increased from 7% in 2015 to 9% in 2017. Not major increases, but renewables seem to be holding steady despite the uncertainty of the market.
Still, today, the only certainty is uncertainty. Although no one really knows when oil prices will stop falling, it’s probably a good idea not to trade in the Prius for that 1974 Stingray you’ve been dreaming about. The days of gas lines may be behind us, but not even John Castellano can look into his crystal ball and predict what lies ahead.