US oil industry business models to change post-recovery: Fuel for Thought

Green shoots of optimism are poking through the parched ground of the oil patch lately as industry focuses on the aftermath of a downturn they hope has troughed. But the US E&P sector that emerges from the latest carnage will be different as business models will be forced to change. With crude oil hanging just shy of $40/b, industry-watchers say capital is still available to survivors of the downturn that are in relatively good financial shape. But lending criteria will be stricter as more will be asked of borrowers and production hedges may be more prevalent, they say. Nearly $39 billion of private equity funds were raised in 2015, and on top of that there was a "substantial" amount of dry powder remaining from funds raised in 2014, Doug Reynolds, managing director and head of US business for Scotiabank, said at the Hart Energy Capital Conference last week. "The majority of US production is owned by companies that are financially strong and there is new equity [raised] that will make them more so," Reynolds said. US E&P companies have recapitalized to the tune of nearly $11 billion in equity so far this year, compared to $8.6 billion in Q1 2015, he and others noted. While many oil companies will likely disappear, victims of liquidations and takeovers, "we think for the guys that make it through, it will be somewhat of a golden era for them," Reynolds said. But they will have to be fiscally lean and efficient. For one thing, lenders may be skeptical of companies whose acreage is not top-tier or industry-proven as they have seen many bankruptcies in the current downturn A recent count by law firm Haynes and Boone put oil industry bankruptcies north of 50.

Focus to stay onshore for faster returns During the downturn, oil companies produced from their best, highest-return wells. They have also concentrated on land plays since the returns are quicker, unlike offshore projects, which can take as long as 10 years to come onstream. The shift to onshore production is expected to continue due to the lower costs and speedier returns available. And while well costs have come down both onshore and offshore due to concessions from oilfield service companies, offshore wells have not experienced the astounding efficiency leaps that have been such a large part of the shale revolution onshore and allowed those operators to survive sub-$50/b oil. Costly or lengthy projects in the US will be "challenged" going forward, Wil VanLoh, CEO of private equity firm Quantum Energy Partners, said at the Hart gathering. The downturn will refocus public oil companies on making money more quickly rather than growing production and reserves. This will "materially" alter or even eliminate certain business models, such as long-cycle projects in deepwater and international arenas, or high-cost projects in the Gulf of Mexico, oil sands, upstream master limited partnerships and the bottom 50% of resource plays, VanLoh said. Only the exceptional of these projects will be moved forward. In addition, the private equity model of funding may be changed post-recovery, VanLoh said. "The model where you lease land, drill a few wells and flip [the developed assets] to a public company is likely a thing of the past," he said. "Public companies have much less money to buy this stuff now, and they have a lot of acreage of their own," he added. "PE-backed companies will have to more fully develop their assets, requiring more money and more time, so quick flips won't be as prevalent." Going forward, debt capital will be harder to get and cost more, while acquisitions will require more equity and that should drive down the prices of assets. "Expect more erratic prices, capital markets, and [mergers, acquisitions and divestiture] activity," VanLoh added. Also, hedging production to protect revenues will likely figure more into the equation. "Public and private companies will have to hedge more for a period of time to get deals done," he said. Lenders may also be under more stringent requirements to determine what a given company's borrowing base should be with everything from interest coverage to debt asset ratios getting a fresh look, analysts said. Borrowers will also have more responsibility. They will need to prove their price forecasts, and the viability of their budgets, and how they will achieve positive cash flow, Deborah Byers, US oil and gas leader for EY, formerly known as Ernst & Young, said. "There will be a lot more rigor around forecasts that are presented to support borrowing bases," Byers said.